Adjustable rate mortgages - What You Need to know

Dan rafter
Written by
Dan Rafter
Read Time: 8 minutes

Adjustable-rate mortgages (A.R.M.s) have been out of favor for some time, but may be on the verge of making a comeback. With mortgage rates seemingly poised to finally begin moving upward again, the potential savings offered by ARM rates could once again start drawing borrowers back to them.

Because you aren't locking in a rate for a long time, ARM mortgage rates are lower than those on fixed-rate loans, at least initially. Initial rates on a 5-1 ARM sometimes run a full percentage point or more below that of a comparable 30-year fixed rate mortgage, so the savings can be significant.

And because most people don't need to lock in a rate for 30 years – they often relocate well before the mortgage is paid off – a 7-1 or 5-1 ARM can often make a lot of sense.

Unfortunately, there's a lot of misunderstanding surrounding adjustable-rate mortgages. Here's a quick rundown of the key things to know about them.

1 – Adjustable-rate mortgage definition

An adjustable-rate mortgage, is a loan where the rate can fluctuate over time, as opposed to a fixed-rate mortgage where the rate never changes. The rate adjusts according to a preset schedule, often once a year, to reflect current market rates. So the rate can go up or down, depending on what the market is doing. They're sometimes called variable-rate mortgages as well.

Most ARM mortgages are "hybrid" loans with a fixed rate for the first few years before the rate starts adjusting, usually after 3, 5, 7 or 10 years, after which the loan usually adjusts eery year after that. A 5-1 ARM is a loan where the rate is fixed for five years, then resets every year after that; a 7-1 ARM is a fixed rate for the first seven years and so on.

Not all ARM rates reset every year - you might get a 7-2 ARM, for example, although annual adjustments are the most common.

2 - They aren't "exotic" or "toxic"

Though they got a bad name during the early 2000s housing bubble, adjustable rate mortgages are actually a very traditional, mainstream type of financing. In many countries, they're the main type of home loan.

ARMs got a bad reputation during the housing bubble because they often came loaded with features that made it easy for borrowers to get into financial trouble - things like artificially low "teaser" rates that disguised the true cost of the loan.

Fortunately, those "toxic" features have virtually disappeared from the market. These days, a lender is unlikely to offer you anything other than a plain vanilla ARM on a residential unless you're a high-end borrower used to dealing with complex financial products.

3 – ARM vs fixed-rate loan

Adjustable rate mortgages are an ideal loan product for people who don't expect to stay in a home for an extended period of time. The typical home is resold about every seven years - meaning the owner has moved on. If you expect to relocate in a few years or are buying the property as a short-term investment, an ARM mortgage is a great product. Why lock in a mortgage rate for 30 years if you're only going to own the home for five?

However, if you're buying what you intend to be your permanent home, a fixed-rate mortgage is probably your better choice. With rates still unusually low by historic standards, those who anticipate owning their home for 10 or more years will likely benefit by locking in today's rates for the long haul.

4 - Rate increases are limited

A lot of borrowers are concerned that if they get an ARM mortgage, the rate may eventually spiral out of control once it starts adjusting. That's a real concern, particularly if you end up owning the home longer than you expect.

Fortunately, increases in ARM rates are capped. First, there's a limit on how much your rate can increase each time it adjusts. Second, many adjustable rate mortgages also include a lifetime cap on just how high the rate can go.

So even if you pay the loan off over 30 years, the rate will never go higher than that lifetime cap. Both of these must be disclosed in the HUD-1 Settlement Statement provided to you before closing the loan.

During the early 2000s, many adjustable rate mortgages were set up to allow or practically require large increases in the interest rate as soon as it started to adjust, which is how many borrowers got in financial difficulty. So keeping a close eye on those adjustment caps is critical when getting a variable-rate loan.

It's worth noting that ARM rates can adjust down as well as up, depending on market conditions. Many people who bought homes with 7/1 or 5/1 ARMS in the decades prior to 2008 benefitted from the gradual decrease in mortgage rates during that time, as their ARM rates kept resetting lower and lower.

5- Understanding the margin

When ARM rates adjust, the new rate is based upon a rate index that reflects current lending conditions. The new rate will be the index rate plus a certain margin established at the time you took out the loan. So if the index is at 3.5 percent when your rate readjusts and your margin is 2 percent, your new rate will be 5.5 percent.

That's assuming that your rate caps, described above, allow such an adjustment. If your original rate was 3.25 percent, and your adjustment cap was 2 percent, your first adjustment can't go higher than 5.25 percent, no matter what the index does.

Some of the most commonly used rate indexes for adjustable rate mortgages are one-year Treasury securities, the London Interbank Offered Rate (LIBOR) and the Cost of Funds Index (COFI). Some lenders may use their own proprietary index. In any event, the index to be used it is disclosed as part of originating the loan and remains in force for the life of the loan.

6- What about those toxic features?

To be sure, many people are still uncomfortable with the notion of ARM mortgages, given what was going on a decade ago. And it is possible you could still encounter adjustable rate mortgages with so-called "exotic" features - it's just that you're not likely to run into them these days unless you're a sophisticated borrower seeking a high-value loan from a specialty lender.

In fact, most of the things that made certain loans toxic during the bubble are now prohibited in mortgages backed by Fannie Mae, Freddie Mac, the FHA or VA - which account for nearly all middle-class mortgages in this country. But to be on the safe side, here are some of the things to look out for if you find them in an ARM offered to you:

Teaser rate: A low initial rate that can climb above-market rates for ARMs when it resets. Here's a test: check the loan's adjustment margin and add it to the current rate of the designated index. If that produces a rate that's notably higher than the initial rate other lenders are offering you, it's likely a teaser rate.

Interest-only loans: When your loan payments during the fixed-rate period only cover interest and do not make any progress on paying down principle. When principle gets thrown into the mix after the first adjustment, the loan can easily become unaffordable. This is a popular feature for sophisticated borrowers who don't want their money tied up in a mortgage but can be deadly for the average consumer.

Negative amortization: Like an interest-only loan, except that your payments don't even keep up with the interest charges, so that your loan balance grows over time. Also popular with sophisticated borrowers, but not a good choice for the average person.

Pre-payment penalties: This is a charge incurred if you pay the loan off early - not just before the rate adjusts, but potentiallly any time during the scheduled amortization of the loan (usually 30 years). Since that's what happens if you sell the home or refinance the mortgage before the rate resets, having to pay a penalty could wipe out much of the advantage of having a variable-rate loan in the first place. Unless you're taking out a "no closing cost" loan, where the closing costs are actually paid through a higher interest rate, you shouldn't have to accept a pre-payment penalty on any mortgage.

Again, adjustable-rate mortgages aren't for everybody. But for certain homebuyers - particularly those expecting to move again in a few years - they're a great product. If you're a regular homebuyer seeking a conventional mortgage from a mainstream lender or credit union, you owe it to yourself to at least check them out.

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