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Benefits And How Do Adjustable Rate Mortgages Work?

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Benefits And How Do Adjustable Rate Mortgages Work?

This BLOG On Benefits And How Do Adjustable Rate Mortgages Work Was UPDATED On April 5th, 2018

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 term.

  • How Do Adjustable Rate Mortgages Work is they have a starter fixed rate for a certain amount of years
  • 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
  • This 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 (Rates are for illustration purposes only and does not reflect today’s rates)
  • If we take the 3/1 ARM example offered an initial interest rate of 3.25% the for the first three years of the loan

Index On Adjustable Rate Mortgages

Lenders base adjustable rate mortgages on the index plus the margin.

  • The way on How Do Adjustable Rate Mortgages Work is every lender who offers adjustable rate mortgages
  • Lenders 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
  • The margin remains the same for the life of the ARM
  • On this case, lets say the mortgage lender will set the margin at 3% for illustration purposes
  • So when a borrower selects the 3/1 ARM loan, they will get the 3.25% interest rate for the first three years
  • 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
  • This depends 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
  • This 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

Types Of Adjustable Rate Mortgages

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, lets take a case scenario:
    • borrower chooses the 3/1 ARM with the initial 3.25% rate
    • margin of 3.0%
    • ARM is based on the one year Constant Maturity Treasury index ( CMT )
    • 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 versus fixed rate mortgages
  • First time home buyers 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
  • This is due to the lower interest rates ARM’s offer versus 30 year fixed mortgage rates

Mortgage Rates On Adjustable Rate Mortgages

How Do Adjustable Rate Mortgages Work with mortgage rates is that there is an initial start rate for a certain period. It then adjusts every year for the 30 year mortgage term.

There are cases where loan officers recommend borrowers with higher debt to income ratios to go with an adjustable rate mortgage than a fixed rate mortgage due to the lower interest rates.
  • Cases where a home loan borrower has borderline qualifying debt to income ratios and due to an increase in monthly payments like higher than expected homeowners insurance premiums
  • Unfortunately, when qualifying borrowers on an adjustable rate mortgages, lenders will add 2.0% over the initial starter rate and use the inflated rate for qualification purposes
  • Borrowers with higher than expected debt to income ratios cannot use adjustable rate mortgages as a solution in lowering their DTI for qualification purposes
  • Unfortunately many loan officers do not know this and does not come up until the end of the mortgage process
Risk factor in selecting an adjustable rate mortgage over 30 year fixed rate mortgages are the risk of the index increasing substantially.  However, due to annual caps, the mortgage loan borrower is somewhat protected in their mortgage payments substantially increasing after the fixed rate period is over.

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