Adjustable Rate Mortgages: Explained
By Gustan Cho
Adjustable rate mortgages, also known as an ARM, are 30 year rate mortgages but the interest rates are not fixed for the life of the 30 year mortgage loan term. Adjustable rate mortgages have a fixed rate for a certain amount of years and after that term is up, the interest rates will adjust every year throughout the 30 year period based on the index and margin. The margin is a set constant rate. The index is what causes the interest rates to adjust every year. There are 3/1 ARM, 5/1 ARM, and 7/1 ARM adjustable rate mortgages. The shorter the fixed rate period is, the lower the initial interest rate will be because the mortgage lender has less risk. For example, a mortgage lender may offer a 3.25% interest rate on a 3/1 ARM, a 3.5% interest rate on a 5/1 ARM, and a 3.75% interest rate on a 7/1 ARM. If we take the 3/1 ARM example, the mortgage loan borrower will be offered an initial interest rate of 3.25% the for the first three years of the loan. The mortgage lender will base the loan on an index. Every lender who offers adjustable rate mortgages will go off an index such as the one year London Interbank Rate ( LIBOR ), or the one year Constant Maturity Treasury, also known as the CMT. The mortgage lender also will set a fixed constant margin which remains the same for the life of the ARM. On this case, lets say the mortgage lender will set the margin at 3%. So when a borrower selects the 3/1 ARM loan, they will get the 3.25% interest rate for the first three years and every year after that, the interest rates will adjust for the balance of the 30 years based on the index and margin.
Caps On Adjustable Rate Mortgages
Adjustable rate mortgages have annual caps and lifetime caps on interest rates. As discussed earlier, the initial rate is fixed for either the first 3 years, 5 years, or 7 years depending on which ARM program the borrower chooses. Thereafter, the interest may go up depending on the index. In the event if the index rate goes up significantly, the cap will protect the borrower because the cap will prevent the interest rate and mortgage payment from escalating more than the capped amount. Most interest rate caps are at set at one or two percent a year and the lifetime cap is capped at 6% over the lifespan of the mortgage loan.
Most mortgage lenders who offer adjustable rate mortgages have a clause on the note that the interest rate after it adjusts after the initial fixed rate period cannot be lower than the starter rate. For example, if the borrower chooses the 3/1 ARM with the initial 3.25% rate with a margin of 3.0% based on the one year Constant Maturity Treasury index ( CMT ) and the Constant Maturity Treasury is at 0.01% after the 3/1 ARM adjusts, the new interest rate will be the 3.0% margin plus 0.01% CMT index which yields 3.01%. The new adjusted ARM of 3.01% ARM is lower than 3.25% so the adjusted adjustable mortgage rate after the 3 year fixed rate period is over will still be at 3.25% because the 3.01% is lower than the starter rate of the 3.25%. The one year Constant Maturity Index is the most conservative index.
Why Should I Go With An Adjustable Rate Mortgage Than A 30 Year Fixed Rate Mortgage?
Adjustable rate mortgages offer lower interest rates than 30 year fixed rate mortgages. A home buyer can most likely get a 0.50% lower interest rate by going with an adjustable rate mortgage than a fixed rate mortgage. Those home buyers who are first time home buyers and are buying a starter home and plan on upgrading to a larger home in 5 or so years may benefit more by getting an adjustable rate mortgage due to the lower interest rates ARM’s offer over 30 year fixed mortgage rates.