Real Estate Financing and Investing/How To Shop for an Adjustable Rate Mortgage

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An ARM is a mortgage where the interest rate is not fixed but changes over the life of the loan. ARMs are often called variable or flexible rate mortgages. Adjustable rate mortgage (ARM) often feature attractive starting interest rates and monthly payments. But you face the risk that your payments will rise. Pluses of ARMs include:

  • You pay lower initial interest (often 2 or 3 percentage points below that of a fixed rate) and lower initial payments, which can mean considerable savings. This means that ARMs are easier to qualify for.
  • Payments come down if interest rates fall.
  • Loans are more readily available and their processing time is quicker than fixed rate mortgages.
  • Many adjustables are assumable by a borrower, which can help when it comes time to sell.
  • Many ARMs allow you to prepay the loan without penalty.

Some of the pitfalls of ARMs include:

  • Monthly payments can go up if interest rates rise.
  • Negative amortization can occur. Note: Negative amortization occurs when the monthly payments do not cover all of the interest cost. The interest cost that is not covered is added to the unpaid principal balance. This means after making many payments you could owe more than you did at the beginning of the loan balance.
  • The initial interest rates last only until the first adjustment, typically six months or one year. And the promotional or tease rate is often not distinguished from the true contract rate, which is based on the index to which the loan is tied.

Tip: It pays to get an ARM if you are buying a starter home or expect to move or be transferred in two to three years.

Recommendation: You should consider a fixed rate loan over an ARM if you

  • Plan to be in the same home for a long time.
  • Do not expect your income to rise.
  • Plan to take sizable debts, like auto or educational loans.
  • Prize the security of constant payments.

When you shop for an ARM (or for any other adjustable rate loan), you should carry the following checklist of questions to ask lenders:

  • What is the initial loan rate and the annual percentage rate (APR)? What costs besides interest does the APR reflect? What are the points?
  • What is the monthly payment?
  • What index is the loan tied to? How has the index moved in the past? Will the rate always move with the index?
  • What is the lender`s margin above the index? Tip: The margin is an important consideration when comparing ARM loans, because it never changes during the life of the loan. Remember: Index rate + margin = ARM interest rate.

Example:
You are comparing ARMs offered by two different lenders. Both ARMs are for 30 years and amount to $65,000. Both lenders use the one year Treasury index, which is 10%. But Lender A uses a 2% margin, and Lender B uses a 3% margin. Here is how the difference in margin would affect your initial monthly payment:

Lender A Lender B
ARM Interest Rate 12%(10%+2%) 13%(10%+3%)
Monthly Payment $668.60 @12% $719.03 @13%
  • How long will the initial rate be in effect? Will there be an automatic increase at the first adjustment period, even if the index has not changed? What effect will this have on monthly payments?
  • How often can the rate change?
  • Is there a limit on each rate change and how will the limit affect monthly payments?
  • What is the "cap," or ceiling on the rate change over the life of the loan?
  • Does the loan require private mortgage insurance (PMI) and how much does it cost per month?
  • Is negative amortization possible?
  • Is the loan assumable?
  • Is there prepayment penalty?