Adjustable Rate Mortgages for Dummies

Adjustable Rate Mortgages for Dummies

Many people are taking advantage of this low interest rate environment to purchase a new home. With such low rates, many consumers are buying new homes. It's far out of most people's memories that interest rates on mortgages were over 10% back in the early '80s.


Unless you're paying for the house in cash, you will need to take out a mortgage. Most people are familiar with the fixed variety. But did you know that there are more alternatives in the marketplace? These different options might make more sense for you. 


Adjustable-Rate Mortgages certainly have a place in the market today, and many consumers are opting for them. No these aren't subprime loans. If you remember from the financial crisis, subprime loans were high-risk loans given to borrowers who had questionable credit or unverified income sources. 

Mortgages for Dummies


Defining an Adjustable Rate Mortgage 


An adjustable-rate mortgage, also known as an ARM, has an interest rate that can change over the term of your loan. Most of us who are carrying a mortgage, probably have a fixed rate variety. Chances are we don't even remember the exact interest rate. But we do know our home payment. That cannot change over the life of the loan. 


What many people don't understand is that an ARM has an interest rate that can go up, but it can also go down. So in theory, your mortgage payment could go both up and down.


Now there is only one reason anybody would ever want to sign up for an adjustable-rate mortgage


  • An ARM has an interest rate that will always start out lower than the fixed-rate variety

  • This means consumers will have an initial lower house payment


Low interest rates have been around for some time now. WIth hints by the FED, these won't be going away anytime soon. 


Components of an ARM 


  • There will be an introductory teaser rate. This is the time when the consumer enjoys the lower interest rate and thus the lower mortgage payment. Your teaser period could be just 12 months. Or it could be even longer, perhaps 36 or even 60 months. The good news is that during this time, your interest rate cannot change. 


  • Now after the intro period expires, your rate can adjust. Your particular loan might have several adjustment periods. Before you sign on the dotted line, you will know exactly how many adjustments yours will have. 

  • Now each adjustable-rate mortgage will be tied to a specific index that will determine your benchmark interest rate. The index will reflect current market conditions. Your lender will tell you which index they are using. If conditions in the marketplace change, expect a rate adjustment with your particular loan. 


  • Finally, CAPS will exist which will limit how much rates can go up each adjustment period and over the life of the loan. CAPS are built-in to protect your payment from spiraling out of control. 

Adjustable Mortgages for Dummies

How ARM's Work in the Wild 


Let's go over some of the more popular examples of ARM's and how they work. 


1/1 ARM: The initial teaser period in this example is just for one year. After the first 12 months expires, the first adjustment will kick in. A new adjustment period will then occur every year thereafter until the home is paid off or sold. The 1/1 usually has the lowest interest rate of an ARM.


5/1 ARM: In this scenario, the consumer has a full 5 years, or 60 months before any adjustment takes place. Any interest rate spike during the first few years won't affect the mortgage payment. After 5 years have expired, then the rate is free to adjust. Subsequent adjustments will then occur every 12 months for the life of the loan.


3/3 ARM: Again the teaser period lasts for 3 years or 36 months. However, there are fewer adjustment periods in this scenario. The first adjustment will then last for 3 years or 36 months. Each subsequent adjustment will also last for 3 years. This means that if rates were to go down during the middle of an adjustment period, you would have to wait for that period to terminate before the rates could reset again. So rates will adjust on year 4, 7, 10, and so on.


Consumers who Should Consider an ARM

  • You purchased a home so your kids could be zoned to a specific school. You know you will be listing your home and moving after they graduate. This might be the perfect scenario for an ARM. It's possible you could move out before the rate had a chance to reset.  


  • Maybe you know the housing market will be hot in a few years in a particular neighborhood. Chances are high you can make a handsome profit and you will be out of the house in a few years. 

  • For someone whose income will be increasing in the foreseeable future. This consumer will take the lower payments today because they will be able to afford the rate increases with their higher income in the future. 

People Who Should Avoid an ARM


  • People who are on a fixed income should always choose a fixed-rate mortgage. These sorts of people know exactly how much they have coming in and made financial decisions based upon this number. If rates spiked and caused the mortgage payment to increase, these sorts of consumers may not be able to make the higher payments. 


  • Consumers who are purchasing a home and know they will be spending a significant amount of time in the home should opt for the fixed variety. 

Adjustable Rate Mortgages

Final Takeaways


  • Consumers should understand all the risks involved with adjustable-rate mortgages before they sign on the dotted line

  • The only reason ever to assume an ARM is for the initially lower interest rate. 

  • An ARM will have a series of adjustments that can cause the rate on the loan to go up or down

  • Your interest rate will be tied to a benchmark. This index will be defined in the paperwork. 

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