Adjustable Rate Mortgages are often an option many don’t want to touch with a ten foot pole. However, what you really could be doing is avoiding your very best option. Here’s why…
Back before the financial crisis of 2008, Adjustable Rate Mortgages (ARMs) were pretty popular. In fact, they made up a significant percentage of home loans. Nowadays, not only are they a lot less popular statistically, they’ve gotten a pretty bad rap. So are ARMs really as bad as their reputation makes them out to be? Short answer: It depends (of course it does, it’s the Mortgage Industry…right?) Now we’ll tell you why…
First thing’s first…what is an ARM loan?
Adjustable Rate Mortgages (ARM) offer a fixed rate period followed by adjustments in the interest rate at pre-determined intervals thereafter. As such, they often come with some of the lowest interest rates available out front!
Breaking It Down
There are all different types of Adjustable Rate Mortgages. Just a few examples are 5/5, 3/1, 5/1, 7/1, & 10/1 ARMs. What exactly do those numbers mean?
• First Number – The amount of time your introductory or initial rate stays fixed.
i.e. In a 5/1 ARM, your introductory rate would stay fixed for 5 years
• Second Number– How often the rate can change
i.e. In a 5/1 ARM, your rate would change every year (1) after the first 5 years
So the rate stays fixed for a pre-determined amount of time, then can either go up or down depending on the following…
Rate indexes and margins
The fixed rate period will eventually end, and after that your rate will either rise or lower depending on another rate called the index. This value is set by market forces and is always published by a neutral party. There are several different types of indexes, so your loan documents will specify which index your particular ARM follows.
Once your index value is determined, your lender will then add a certain number of percentage points, called the margin. Margins are fixed for the life of the loan and determined by what specific ARM product you choose. The index plus the margin is your fully indexed rate. This is will be the current rate on your ARM loan.
Let’s look at an example…
Let’s say you select a 5/1 ARM (the most popular in fact) and your rate for the fixed-rate period has an index of 1.25% and a margin of 3 percentage points. You would add them together to get your rate for the first 5 years of your loan, which would be 4.25%. After the fixed-rate period ends, the index is at 1.75% and the margin stays fixed at 3 percentage points. Your new rate would be 4.75% for that year. However, keep in mind that with this particular scenario, the rate can change every year thereafter (thus the “1” in 5/1 ARM). If it were a 5/5 ARM, it would change every 5 years after the first initial 5.
Ok, we know what you’re thinking. What if the index just goes up and up and up?! Not to worry, that’s why ARMs come with rate caps that are dependent on the type of ARM loan you choose. There are a few different kinds of caps so that you will be safe from any outrageous jumps in your rate. The following are the different types:
- Periodic Rate Cap– limit to the percentage the interest rate can change from year to year
- Lifetime Rate Cap – limit to the percentage the interest rate can change over the life of the loan
- Payment Cap – limit to how much the monthly payment can rise (in dollars) over the life of the loan
That’s a lot of information! So here’s the Cliffs Notes version of it all…
Pros and cons of adjustable rate mortgages:
Pros of Adjustable Rate Mortgages:
- Usually have lower rates
- After the fixed-rate period, the rate can actually go lower (an option not many consider!)
- Are protected from huge rate jumps by rate caps
Cons of Adjustable Rate Mortgages:
- Uncertainty about the interest rate market
- Unpredictability about how much your monthly payment will be in the future
Situations Where An ARM Loan May Be Your Best Option
- You know you won’t be in the home very long (I.e. military families or families that move around a lot for their careers)
- You know you will be receiving a raise or salary bump in the near future
- You know you’ll be receiving an inheritance or access to a trust fund in the near future
- You know the home will be a starter home and you will not be in it forever
- You know you’d like to do a refinance within 5-10 years of owning the home
There you have it…the good, the bad and the super confusing parts of ARM loans. As you can see, there are so many situations that an ARM loan could be your best option.
In a nutshell, don’t pay more for a 30-year loan price if you don’t have to. The aforementioned circumstances really merit a hard look at taking advantage of this unique loan type and having a significantly lower rate.
In conclusion, ARM loans really aren’t as scary as some may think. If you’re in the right situation, they can actually be your very cheapest option. Still hesitant? Make sure you let one of our trusted Mortgage Loan Officers guide you through the process of choosing the right option for you. Before you apply, keep in mind that Southern Trust offers several different types of ARM loans including 5/5, 5/1 and 10/1. We’ll be sure to find the perfect one for you!