Thursday, November 22, 2012

Adjustable for Rate Mortgages

These are mortgage programs that offer lower fixed rates for a limited period of time after which the interest rate will adjust. These loans are often quoted as a 3/1 or 7/1, where the first number represents the initial fixed rate period and the second number represents the frequency at which the rate will adjust after the fixed rate period. Most lenders offer initial fixed rate periods for 1, 3, 5, 7 and 10 years after which the rate will adjust every 1 year thereafter.
For example: a 3/1 ARM with a rate of 6.00% indicates a fixed rate for 3 years at 6.00% which will adjust every 1 year thereafter. Hence, a 3/1 ARM.
ARMs generally carry a lower rate of interest than a 30 Year Fixed rate mortgage. The trade off is the risk, after the initial fixed rate period, that the interest rate will increase over a period of time.
When shopping for an ARM, here are some things you should know:
What is the maximum an ARM can go up or down when it adjusts?
The maximum a rate can go up or down varies depending on the mortgage lender and the initial fixed rate period. When shopping for an ARM you need to determine the loan's caps, margin and index.
What are Caps?
There are normally 2 Caps; a per adjustment cap and a lifetime cap. A per adjustment cap is the maximum a rate can go up or down in any adjustment year. A lifetime cap is the maximum the rate can go up over the full term of the loan. For example: a 2% per adjustment cap means the maximum your rate could go up or down in any adjustment year is 2% over the current rate. If the current rate on your ARM is 6.00% the maximum rate you could be paying in the next adjustment year is 8%. A 6% lifetime cap means that the maximum interest rate you could ever pay in any year is 6% over the start rate or 12%. Your new rate is tied to an index to which the lender adds a margin.
What is an Index and Margin?
Mortgage interest rates are tied to current market conditions and a good measure of market conditions are yields on treasury securities. The index is normally the weekly average yield on a 1, 3 or 5 Year Treasury Security 30 or 45 days prior to your adjustment date. Keep in mind a 1 Year Treasury yield is lower than a 5 Year Treasury yield.
To this index, the lender will add a margin of X% determined solely by the lender. A lender could add a margin of 2.25%, 2.5% up to or greater than 3% to the index to determine your new rate. When shopping for an ARM you want to look for the lowest term treasury security index with the lowest margin.
What does all this mean?
The Caps, Margin and Index play an important deciding factor when shopping for an ARM. For example; you have been quoted the following rates and terms on a 3/1 ARM both with a 1 Year Treasury Security index:

  • Loan #1 - Rate 6.00%: Caps are 2% per adjustment, 6% lifetime with a Margin of 2.75%
  • Loan #2 - Rate 6.125%: Caps are 2% per adjustment, 5% lifetime with a Margin of 2.50%
On the surface, loan #1 looks like the better loan since the interest rate is .125% lower than loan #2 and that holds true if you plan on moving or refinancing your loan at the end of the three years. But if there is a chance you will keep the loan beyond 3 years, loan #2 is probably the better way to go because 1) when loan #2 adjusts, the rate will always be .25% below loan #1 (unless is adjusts the full 2%) and 2) the lifetime cap is a full 1% lower than loan #1.
How do I decide if an ARM is right for me? Here are some things to consider:
The initial fixed rate period is perhaps the most important factor when determining whether or not an ARM is for you and second most important is the margin and index.
  • Do you plan on remaining in your home for a period of time which is less than or equal to the initial fixed rate period of the loan?
  • If you move or are frequently relocated by your employer, an ARM may be for you. An ARM will provide you with a lower interest rate and payments for the amount of time you plan on being in your home. Do you plan on being in your new home for 5 years? A 5 year or 7 year ARM may be the best way to go.

  • Do you think you may refinance your loan over the next X number of years? Statistics show most homeowners either move or refinance their mortgage within a 7 year period. If you believe these statistics, or have experienced it yourself, a 7 or 10 Year ARM could be for you.

  • Do you need a low rate of interest to qualify for the home of your dreams? Since an ARM generally offers a lower rate of interest than a fixed rate mortgage, you may be able to qualify for a higher loan or more expensive home. Keep in mind, however, unless you're in a position to refinance the loan in X number of years, the interest rate may go up and you want to make sure you can still cover the monthly payments. If you have the available funds, you may be better off with a fixed rate mortgage and lowering this rate by paying points.
ARM's are not for everyone. If the possibility of having to refinance or paying a future higher interest rate is not for you, you may be better off with a fixed rate mortgage.