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%
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.
