Adjustable- Rate Mortgages (ARMs)

An adjustable-rate mortgage (ARM) has an interest rate that can adjust at particular points throughout the lifetime of the loan.  Most ARMs offer a fixed interest rate for a specific length of time (3,5,7 or 10 years), after which time the interest rate adjusts to match current interest rates.  At whatever time the interest rate changes, then your monthly payment will also adjust. (Your payment will increase if there is a rise in the interest rate or decrease if there is a decrease in the interest rate).  Comparable to fixed-rate mortgages, ARMs typically come with 15- or 30-year terms. At the end of this term, you will have paid off the principal plus interest.  The total amount of interest paid on the loan will differ depending on:

• Interest-rate variation throughout the lifetime of the loan
• The terms of the loan, like how frequently it adjusts

The following table shows the primary advantages and disadvantages of adjustable-rate mortgages.

How the Interest Rate of an ARM Adjusts

The rate index and margin establish how the interest rate of an ARM changes after the expiration of the fixed-rate term.

• Rate Index: An ARM’s interest is linked to one of several rate indexes, like the interest rates of U.S. Treasury bills or CDs.  When the interest rate of the reference index that an ARM is based on increases or decreases, so does the interest rate of the corresponding ARM.  When comparing the index rates of two ARMs, make sure that the loans are based on the same index.  The index rate in the interest rate of the ARM, not including the margin (this is explained below).
• Margin: The markup that the lender adds to the index rate.  The total of the markup and the index rate is known as the fully indexed rate.  Typically, lenders add a margin of 2-4%.  This means that an ARM having an index rate of 5% would probably have a fully indexed rate of 7-9%.

When shopping for an ARM, you should always be sure that the fully indexed rate of the loan has been fully evaluated, not just the index rate.  Also, you should be cautious about loans with teaser rates- introductory interest rates that are much lower than the fully indexed rate of the loan but frequently last for as little as a single month.  Ignore teaser rates altogether and focus on the rate that goes into effect at the end of the fixed-rate term of the ARM.

Other Characteristics of ARMs

There are several other significant terms you should be aware of when considering getting an ARM:

• Adjustable frequency: When the fixed-rate term ends, ARMs adjust interest rates at specific intervals: some loans adjust once per month, while others change semiannually, annually, or every couple years.  When comparing two ARMs, the loan that is adjusted the least often is a better selection, assuming that all other factors are the same.
• Convertibility: Convertibility is a feature that allows conversion of an ARM into a fixed-rate mortgage.  Convertible ARMs ordinarily have comparatively high fully indexed rates as compared to other ARMs.
• Caps: Caps are the limits on the amount that an ARM’s interest is allowed to adjust from one interval to the next, as well as the total amount that an ARM’s interest rate can change over the lifetime of the loan.  For example, an ARM may have a 2/6 cap, which means that the rate can fluctuate up or down by no more than 2% in  any one adjustment period, and that it can fluctuate up or down no more than 6% total over the life of the loan.  When comparing two similar ARMs, the choice with the more stringent caps is typically the best selection.  You should never select an ARM that doesn’t provide a cap on the loan’s maximum interest rate.

Interest-Only ARMs

An interest-only mortgage is a deviation of an ARM that minimizes monthly payments by allowing payments of only interest- not principal.  Interest-only loans generally allow payment of fixed, low, interest- only sums for a specific length of time-usually 5,7,or 10 years on a 30-year term loan.  When the fixed interest-only payments end, these loans convert to conventional ARMs with rates that modify depending on the specific terms of the loan.  When the interest-only period of any interest only loan conclude, there are two choices:

• Start paying off the principal within each monthly payment: This option will cause monthly payments to increase significantly, even if interest rates remain the same.  If interest rates do rise as well, monthly payments could shoot through the roof.
• Pay off the entire balance in one lump sum: This alternative generally calls for a cash payment of tens to hundreds of thousands of dollars at one time.

The Drawbacks of Interest-Only Loans

You should never elect an interest-only loan as a means to purchase a property that you could not afford otherwise.  If you do, you likely will not be able to afford the higher payments that will go into effect once the interest-only term concludes.

The only reason to select an interest-only loan is if you absolutely plan to sell the property prior to the expiration of the interest-only terms and you do not want to invest any more money in the property than the amount of the down payment.  Although if you do select an interest-only loan for this specific reason, you need to be aware of the following drawbacks of interest-only loans:

• Potentially Higher payments: Even if you plan to sell prior to the expiration of the interest-only term, it may be difficult to sell immediately.  If you can’t sell-due to issues such as an economic downturn or a soft real estate market- you could be trapped making higher monthly payments until the property sells.
• Limited Equity Growth: Equity is the difference between the market value of a home and the principal that is still owed on the mortgage.  In an interest-only loan, the monthly payments don’t play a part toward paying down the principal.  Therefore, the equity can only grow if the market value of the home increases.