The distinction between an Adjustable-rate mortgage (ARM) and a fixed-rate mortgage is that interest rates and monthly payments can change over the life of the ARM loan. More often than not Adjustable-rate mortgages (ARMs) initially offer lower interest rates vs. fixed-rate mortgages. Before deciding on an ARM, key aspects to consider would be how long you plan to be in possession of the property, and how often the monthly payment amount may change.
Why choose an adjustable-rate mortgage?
If a homeowner intends to stay in their home for a fairly short period of time then the low interest rate offered by a Adjustable Rate Mortgage (ARM) will of course be very appealing to them particularly when they currently are facing higher interest rates. On the one hand, homebuyers may find it easier to qualify for an ARM versus a traditional loan, however, on the other hand if the homebuyer chooses to stay for the long term or does not like the amount of their loan payment changing each year they may prefer a fixed rate mortgage.
Structure of adjustable-rate mortgages
Adjustable-rate mortgages have three primary components: an index, margin, and calculated interest rate.
The interest rate for an ARM is based on an index. This index examines the lender’s ability to borrow money. Some of the common indexes used include U.S. Treasury Bills and the Federal Housing Finance Board’s Contract Mortgage Rate. All indexes have one thing in common; they cannot be controlled by the lender.
A percentage is added to the Index to cover the lender’s administrative costs and profit. This is called the Margin and is also known as the “spread”; however, even if the Index rises or falls over time, the Margin will normally remain constant over the life of the loan.
- Calculated interest rate
The rate the homeowner pays is calculated by adding the index and margin together. By doing this addition, you will arrive at the Calculated interest Rate. The Calculated Interest Rate is the rate the homeowner pays and the rate which future rate adjustments apply as opposed to the “teaser rate,” explained below.
Adjustment periods and teaser rates
Due to economic conditions, the interest rate for an ARM may change. An important question to ask your lender is about the adjustment period or how often your interest rate may change For example: Many ARMS have one-year adjustment periods this means the interest rate along with the monthly payment is recalculated based on the index each year. Longer adjustment periods may be available; it all depends on who the lender is.
The initial adjustment period for an ARM can also be based on a “teaser rate.” This rate is an artificially low introductory interest rate specifically offered by a lender to catch the attention of homebuyers. The life of a “teaser rate” is usually about 6 months or a year then the loan will revert back to the calculated interest rate. Something to keep in mind is that most lenders won’t use the “teaser rate” when qualifying you for the loan.
Homebuyers are protected from excessive increases in their interest rate because most ARMs have “caps.” The “caps” control how much the interest rate may rise between the adjustment periods and the rise or fall over the life of the loan.
For example, an ARM may be said to have a 2% periodic cap, and a 6% lifetime cap. This means that the rate can rise no more than 2% during an adjustment period, and no more than 6% over the life of the loan. (The lifetime “cap” almost always applies to the calculated interest rate and not to the introductory “teaser” rate.)
Payment caps and negative amortization
Some Adjustable-Rate Mortgages also include payment caps. Payment caps differ from rate caps in that they place a ceiling on how much your payment may rise during the adjustment period. This does sound like a good thing but at times it can lead to trouble.
For example, if the interest rate rises during an adjustment period, the amount of the additional interest due on the loan payment may exceed the amount allowed by the payment cap–leading to negative amortization. This means the balance due on the loan is actually growing, even though the homeowner is still making the minimum monthly payment. Many lenders limit the amount of negative amortization that may occur before the loan must be restructured, but it’s always wise to speak with your lender about payment caps and how negative amortization will be handled.