Adjustable Rate Mortgages are a product that sometimes gets a bad rap. For many borrowers it doesn’t make sense to take out a loan without being absolutely certain what the payments are going to be.
The truth of the matter is that Adjustable Rate Mortgages (or ARMs) are a misunderstood product that sometimes makes perfect financial sense. Deciding if an ARM is right for you starts with knowing the reasons why people choose them in the first place.
Lower Initial Rates. Why would someone get an ARM over a fixed rate? The most straightforward answer is cost- ARMs come with an initial interest rate that is usually much lower than what you would pay on a traditional loan product.
For instance , a $250,000 loan on a 30-year note would run $1266 a month at a 4.5% rate. Switch into an ARM and you’ll be paying closer to $1193 a month.
Rate Decreases. Take a look at financial data from the last few years and it will appear that mortgage rates fluctuate up and down on a regular basis. The picture becomes a bit clearer the further back we go:
Rates tend to drop over time, and borrowers on fixed-rate programs can’t take advantage of this without going through a refinance. Borrowers who have taken out an ARM will see the benefit of a reduced rate as soon as their loans readjust.
Short-Term Ownership. People are working at their jobs less time than ever before (one recent study says five years and falling, and a job change often means relocation.
For borrowers who don’t plan on staying in one place long, or are moving to costly areas, ARMs provide a low-cost alternative to a traditional mortgage.
Is An ARM Right For You?
Now that you understand why people would get an ARM you can determine if it’s the right product for you. Learning how to read each program will help you understand the costs and benefits.
Step 1. Understand The Term. ARMs are presented as a combination of numbers such as 10/1, 3/1, or 5/6. These numbers tell you how often your loan rate will change: the first number represents how long your rate is fixed while the second number shows you how often it will adjust.
For example, a 5/1 ARM will stay at a fixed rate for 5 years and adjust annually afterward. A 3/6 ARM will remain fixed for 3 years with adjustments every 6 months after.
Step 2. Understand the Calculation. There’s a science to how ARM rates are calculated.
Index + Margin = Adjusted Rate
The Index is a rate derived from a financial market (some common ones are below). The change in rates across these markets is what causes your mortgage rate to move up or down.
The Margin is a premium added to your rate by the lender. The two of these combined equal the rate of your mortgage, or Adjusted Rate.
Both index and margin are disclosed up front when starting your loan process.
Step 3. Understand Your Caps. All ARMs have both floors and ceilings that determine the maximum rate change throughout the life of the loan. These numbers are presented in this format:
First Rate Adjustment / Max Adjustment Rate / Total Adjustment Rate
An ARM with a cap of 5/2/6 could only change a maximum of 5% the first time it adjusts, 2% every subsequent period it adjusts, and a maximum change of 6% over the life of the loan. Floors and Caps protect both the lender and the borrower, as these ranges apply to both increases and decreases in the loan rate.
Adjustable Rate Mortgages can be a complicated product but offer significant benefits to those willing to take the time to understand them. Always weigh your options when choosing a mortgage product and remember to consult with a Cendera Mortgage Banker if you need guidance.