Adjustable Rate Mortgages
Rating: Medium to High Risk. Risk can be mitigated by selecting longer initial fixed rate periods.
Description: Adjustable Rate Mortgages, also called “ARMs”, typically have a term of 30 years. Unlike traditional 30 year fixed rate mortgages, the interest rate adjusts periodically after an introductory fixed rate period. For Fannie Mae and Freddie Mac conventional mortgages, the introductory rate is typically fixed for 3, 5, 7 or 10 years. Community Banks & other Portfolio Lenders often offer additional introductory rate periods of 1 or 2 years and shorter terms such as 15 and 20 years.
For Example: A conventional Fannie Mae 3 year ARM is a 30 year mortgage where the interest rate is fixed for the first 3 years of the loan, and then adjusts periodically– either monthly, semiannually, or annually for the remaining life of the loan.
Generally speaking, the shorter the introductory fixed rate period, the lower the interest rate. Therefore a 3 year ARM would have a lower interest rate than a 5 year ARM, and a 5 year ARM a lower rate than a 10 year ARM. Almost all Adjustable Rate Mortgages offer lower initial rates than traditional 30 year fixed mortgages. This makes ARMs attractive to people looking for a lower monthly payment in situations where they are not concerned about the risk of the monthly payment adjusting and potentially increasing once it enters the adjustable rate phase of the loan.
Examples of situations where opting for an ARM might make sense include:

You plan on being in the home for a short period of time & will sell the property before the introductory rate period expires.

You plan on paying off the loan before the introductory rate period expires.

You have a high probability of increasing income, ie. a radiology resident currently earning $40,000 annually but who upon graduating from the program will earn $250,000+ annually and will be aggressively paying down the loan over time or are not concerned about being able to make higher payments if the rate adjusts upwards and your payment increases.

You would like a lower initial interest rate in order to qualify for or your mortgage. 7 year and 10 year ARMs qualify the borrower off of the initial fixed rate, which may make the difference between getting approved of denied for a loan if your debt ratio is tight.
If you are considering an Adjustable Rate Mortgage, you will want to determine what happens once your introductory fixed rate period ends. You should inquire about the following:

When does my introductory fixed rate period end?

How often does the interest rate adjust after the introductory fixed period ends?

How much can the rate adjust per year?

How much can the rate adjust over the life of the loan? (The max rate).

How do you calculate what the rate will adjust to?
To answer #s 2 – 5, you will need to understand what the following terms: Index, Margin, and Caps.
The ARM Rate Caps determine how much the interest rate can fluctuate each adjustment period. Typical caps are….. 5/2/5 or 6/2/6

The first number represents the maximum change for the FIRST adjustment.

The second number represents the maximum change for each subsequent adjustment.

The third number represents the maximum amount the interest rate can change from the introductory rate over the life of the loan.
You also may see caps expressed as…… 2/5 or 2/6. In this scenario the initial adjustment and subsequent adjustments are the same = 2%. The max adjustment over the life of the loan = 6%.
Example #1: If the caps are shown as three numbers: 5/2/5

The first number represents the initial adjustment after the introductory fixed rate period expires.

The second number represents the maximum amount the interest rate can change over each adjustment period.

The third represents the lifetime cap the maximum amount the interest rate is allowed to increase above the initial introductory rate over the life of the loan.
Example #2: You select a 5/1 Year Libor ARM with an initial interest rate of 3% with 2/6 caps.

Your initial rate is 3%

The 5/1 means:

The introductory interest rate of 3% is fixed for 5 years.

The interest rate will adjust every year for the remaining 30 years of the loan.


Your Caps are 2/6

This means your interest rate cannot adjust more than 2% per year (up or down).

The maximum amount the rate can adjust over the life of the loan is 6%.


Therefore after your introductory rate of 3% expires after 5 years, the maximum your rate can go to for year six = 5%; and the maximum the rate can increase to over the life of the loan = 9%.
You calculate the proposed interest rate by adding the Index + Margin. The index ie. Libor Index will vary periodically according to market factors. As industry rates go up, your index will go up. As industry rates go down, your index will go down. While the index varies, the Margin is unchanged and is an additional spread for the lender.
Example: If your index was 3.41%, and the Margin was 2.25%, your rate would be 5.66%. Note that the Index value will change from time to time, but the Margin will always be the same. In this case, 2.25%.
Pros

Starting rates lower than 30 year fixed mortgages.

Lower initial monthly payments.

Great for borrowers that plan on carrying a loan for a predetermined period of time who do not need the long term security of a fixed rate mortgage. For example:

A 1 year ARM may be perfect for someone who plans on payoff the new mortgage within a year.

A 5 year ARM may fit someone who will be moving and selling their property within 35 years.


The lower monthly payment may allow borrowers to afford a mortgage they otherwise would not be able to carry.
Cons

Variable Rates. Once these loans reset, your rate and monthly payment have the ability to increase.

Periodic rate adjustments that are not necessarily competitive with current market interest rates.

If you miscalculate the number of years until you are out of the property/pay off the loan, you may need to refinance incurring additional and unnecessary costs than if you had initially opted for a fixed rate loan.

They can entice borrowers into a loan amount that is greater than they can actually afford.
 You may not be able to qualify to refinance when the introductory rate period ends, leaving you with a much higher monthly payment/interest rate. This was the trap that many homeowners fell into during the housing crisis. Their ARMs adjusted, payments went up, and because home values had dropped and the property couldn’t appraise or the borrower lost their job they were stuck with the higher payments and many lost their homes when they could no longer make the payment.