One of the attractive things about a fixed-rate mortgage is its simplicity: your interest rate never changes, and neither does your monthly payment. With an adjustable rate mortgage, however, your interest rate and payments can fluctuate, and this can cause confusion if you’re not prepared.
An ARM may be less expensive than a fixed-rate loan in the short-term and therefore can be an attractive alternative. But it’s important to understand the following before deciding if one is right for you:
1. How your rate is set
The interest rate on an ARM is calculated according to two figures: the index and the margin. The index is a published rate that changes according to overall market conditions. Lenders may use a number of different indexes including, for example, rates paid on U.S. Treasury securities. The margin is the number added to the index to determine the interest rate on your mortgage. It usually remains constant for the life of the loan. For example, let’s say your ARM’s index is the rate on three-year U.S. Treasury securities, which at the time of writing stands at 4.8 percent. If your margin were 2 percent, then the interest rate on your mortgage would be 6.8 percent. It may, however, be less than this at the start, as most lenders offer low introductory or start rates for a fixed period of time. Typically, the lower the start rate, the shorter the period is until the first adjustment.
2. When your monthly payments change
The index your ARM is based upon may change frequently, but the interest rate of your mortgage is only modified periodically at your adjustment period. Often the adjustment period is six months or a year, though your lender may specify other intervals. Some mortgages have a fixed rate for a number of years, followed by regular adjustment periods. With a 5/1 ARM, for example, your rate will not change during the first five years, after which it will be adjusted annually. Each time your rate is adjusted, your monthly payment will rise or fall accordingly, based on your index and margin.
3. What protection you have
ARMs always carry some inherent risk, but you can be protected from very large or rapid increases in your monthly payment. Virtually all adjustable-rate mortgages have an overall ceiling or cap that limits how high the rate can climb over the life of the loan. For example, say the index goes up to 7 percent and your margin is 2 percent. Without a rate cap, your mortgage would rise to 9 percent. However, if you had a rate cap of 8 percent, you would be protected from having your mortgage go above 8 percent. Most ARMs also have periodic caps that specify the maximum amount the rate or monthly payment can go up in a single adjustment period. Be aware that rate increases that are capped in one year can sometimes carry over to a future year when the index does not rise. Ask your lender if these carryovers apply to your loan.
4. The impact of interest rate swings
The best time to take out an ARM is when mortgage rates are falling. If your loan’s index declines, your monthly payment will drop at the next adjustment period. In an environment of rising interest rates, however, ARMs can be stressful, since your monthly payments may go up at each adjustment period. Even if these increases are capped, you may well find yourself paying more than homeowners with fixed-rate mortgages. Because it can be hard to predict where interest rates are headed, it’s important to understand these potential risks when considering an ARM. It’s also wise to conduct a “stress test” to ensure you can afford to pay the maximum you could be liable for at each adjustment. If you can’t, then an ARM is probably not right for your situation.
5. When it’s time to refinance
It usually does not make sense to refinance an adjustable-rate mortgage if interest rates are falling. If they’re heading upward, however, you may want to consider looking for a new ARM with a lower margin or better protective caps. Or, if you are uncomfortable with the swings in your monthly payment, refinancing to a fixed-rate mortgage can offer peace of mind.
Remember that refinancing always comes with upfront costs that you need to weigh against future savings. Use the LendingTree refinance calculator to help you crunch the numbers.