Adjustable rate mortgages (ARM) can be tricky to understand. There are many variables to consider when you are looking at this financing option. With an ARM, the interest rate is variable meaning that your payment can change throughout the life of the loan. There are certain "safeguards" in place to protect the borrower from dramatic changes. Here are some of the most asked questions EchoBay Loans receives that may help you decide if adjustable rate mortgages are your best home loan choice.
Q: What does it mean to have a variable rate?
A: A variable interest rate means that the rate can change over the life of the loan. On ARMs, the interest rate is figured by adding the index and the margin. Different lenders use different index rates and it is important to know which one is being used. A common index rate is the one-year Treasury Bill. The margin is the additional percentage that the lender adds to the index rate to arrive at the interest rate. For example, if the index rate is 5% and the margin is 2%, the interest rate on your loan is 7%. Keep in mind, the index rate is variable and subject to change, while the margin is typically set for the life of the loan.
Q: When do the interest rates on ARMs adjust?
A: This depends on the type of adjustable rate mortgage you have. The period between rate changes is known as the adjustment period. On a one-year ARM, the adjustment period is once a year meaning the most often the interest rate is subject to change is once a year. Other common ARM loans include the 3/1, 5/1 and 7/1. On these loans, the first number indicates how long the rate remains fixed and the second number indicates how often the rate will change after the fixed period. On the 3/1 ARM, the interest rate will be fixed for the first three years followed by annual adjustment periods thereafter.
Q: What types of interest rate caps exist for ARM loans?
A: There are two types of caps - periodic and overall or lifetime.
The periodic cap sets a limit that the interest rate can increase for each adjustment period. It is common for the periodic cap to be set at 2%. If on your first adjustment, the index had increased by 3% but you have a 2% periodic cap, your rate will only increase by 2%. However, let's assume in the 2nd year of the loan, the index rate remained the same. When your adjustment is due again, it will increase by 1% (to be equal the current rates), even though the index remained unchanged over the past year.
The second type of cap is an overall or lifetime cap. This cap sets a maximum for your interest rate over the life of the loan. If your interest rate was set at 7% and your overall cap is set at 5%, then the maximum your interest rate will be is 12%. Even if the index rate climbs to 15%, you will never pay more than 12% on your loan. However, keep in mind that a 5% change in interest rates can have an enormous effect on your payment.
Q: Is there a way to set a maximum payment amount for an ARM loan?
A: Yes! With some adjustable rate mortgage loans, you will have the option of a payment cap. Rather than limiting the interest rate, this sets a maximum your payment can increase in each adjustment period. Payment caps are generally based on percentages. If your payment cap is 5% and your house payment is $1,000, the maximum your payment could increase to is $1,050 in the first adjustment period. On the second adjustment, it could increase an additional 5% to $1,102.50 and so forth. The downside to this cap is that the amount of interest you owe is being calculated based on the interest rate regardless of your payments. The amount you owe could be increasing at a faster rate than your payments. This can lead to negative amortization.
Q: What is negative amortization?
A: Negative amortization is when your monthly payment does not cover the interest on the loan. When this happens, unpaid interest is added back to the principal portion of your loan and accrues interest again. Ultimately, this can result in owing more on your loan than you originally borrowed. Some lenders will set a limit to negative amortization at 125% of the loan amount. In this example, on a $100,000 loan, your loan balance would not exceed $125,000. However, when it reaches that amount, the lender will likely adjust your payments higher so the loan will still be paid to zero at the end of the term.
Q: What terms are available for ARMs? Does the interest rate depend on the term?
A: Loan terms vary greatly on an adjustable rate mortgage loan. The fixed rate term of the loan can be as short as a year and generally no longer than 10 years. The interest rate is mainly dependent upon how soon the first adjustment period takes place and how often thereafter it occurs. On a one-year ARM, the rate can be very low because the rate is only set for one year. This limits the risk the lender is taking.
On for example a 7/1 ARM, where the first interest rate change won't take place for seven years, the rate will be higher. This is because the initial interest rate is typically lower than that of fixed rate loans at the time. The lender is locking in this low rate for seven years, which is plenty of time for market rates to skyrocket, meanwhile you are still paying a low rate. This scenario equals more risk for the lender, which results in a higher interest rate for you.
Q: Is an ARM loan a good deal for a first-time homebuyer?
A: That depends. Many times, you can qualify for a more expensive home with an ARM loan because the initial payments are lower due to a lower interest rate. However, when rates begin to change, the payments will adjust and may adjust beyond what you are capable of paying.
If you plan to be in the home for a short amount of time, then an adjustable rate mortgage loan may be perfect for you. For instance, if you plan to stay in your home for less than five years, then a 5/1 ARM may be good because you will have sold the house before the first adjustment period occurs. But plans change and you should ensure that you could afford the payments if you have to endure fluctuations in the interest rate and your payment. Your credit rating and your home are at risk if you can't.