Adjustable rate mortgage loans (ARMs) are excellent tools that, when used properly, can save homebuyers and real estate investors thousands of dollars. Understanding how adjustable rate mortgages work is the first step to leveraging them to your advantage. Here are the basics of how ARMs work and how lenders set their rates.
ARM Mortgage Loans 101
You're probably already familiar with fixed-rate home loans. As the name implies, a fixed-rate mortgage has an interest rate that does not change for the duration of the loan. ARMs come with variable interest rates that can change at regular intervals after an initial introductory period.
Your interest rate after each adjustment depends on a number of factors, including the index your ARM is tied to, the lender's margin, and any caps or floors specified in your loan contract. Caps are a safety feature that limit the amount your interest rate and/or payment amount can increase at any given adjustment and over the lifetime of the loan. Floors offer similar protection to the lender because they limit how low the rate can go at any particular adjustment or over the life of the loan.
ARM Mortgage Index and Margin
Every adjustable rate mortgage is tied to an index. Indexes are published measurements of economic activity. Common indexes used to set ARM mortgage rates include the LIBOR (London Interbank Offered Rate) and the COFI (Cost of Funds Index). Margin is simply your mortgage lender's markup on top of the index rate. The index plus the margin is called the "fully indexed rate."
ARM loans adjust at regular intervals according to their terms. The 5/1 ARM, for example, has an introductory rate (also called a "start rate" or "teaser rate") that's fixed for the first five years and adjusts every year after (hence the 5/1 designation). It's important to understand that when your ARM mortgage interest rate changes, your payment could increase, and you should prepare for that possibility.
What Happens if the Index Drops?
It's possible that your mortgage payment could go down if the index value drops. However, it doesn't always if there are floors in place. For example, if your index is the 1-year LIBOR (which is at .63 percent at this writing) and your margin is 2.00 percent, the fully-indexed rate would be 2.63 percent. But if your loan has a 3.00 percent floor, your rate will not drop below 3.00 percent no matter how low the index goes.
What about Interest Rate Caps?
Interest rate caps are a safety mechanism protecting you from unaffordable mortgage payments when your home loan adjusts. There are two kinds of caps you need to be familiar with: periodic adjustment caps and lifetime caps.
Periodic caps protect you by limiting the amount your interest rate can change from one adjustment period to the next. A typical periodic cap is two percent per year. If your interest rate is 3.5 percent, if it has a two percent cap it won't go higher than 5.5 percent at the next adjustment, even if the index shot up to ten percent. This protects your from payment shock when your interest rate goes up.
Lifetime caps limit the amount your rate can change over the entire duration of your loan. A typical lifetime cap is six percent – so if your start rate is three percent, a six percent lifetime cap means your rate cannot ever exceed nine percent. While lenders are required by law to include lifetime caps, you'll want to make sure your ARM also includes periodic caps.
Adjustable rate mortgage loans can save you money because their start rates are lower than comparable fixed-rate mortgages. Rates for 5/1 loans, for example, typically run about a full percent lower than rates of 30-year fixed-rate loans.
However, they are not risk-free. If you have not sold or refinanced your home before the introductory period ends, your interest rate and payment could increase. If your loan becomes unaffordable, there is the possibility of losing your home to foreclosure. If you have a low tolerance for financial risk and need long-term financing, your needs might be better served by a traditional fixed-rate mortgage loan.