How Would an Adjustable Rate Mortgage Affect You?
What is an ARM?
The term ARM stands for adjustable rate mortgage. An ARM is a loan whose rate can, and most likely will, change during the course of the mortgage. The rate on an ARM can go up or down.
Most ARMS contain a period at the very beginning of the loan in which the rate is fixed. The fixed term is generally 1 year, 3 years, 5 years, 7 years, or 10 years, but other periods are available. The shorter the fixed term, the lower the starting rate tends to be. After that, the rate may change, or "adjust" on agreed upon dates, usually it is yearly. So, a mortgage whose rate is fixed for the first 5 years, then adjusts every year afterward, would be known as a "5/1 ARM". Likewise, an ARM whose rate is fixed for the first 2 years and then adjusts every six months would be known as a "2/6 ARM". Home Equity Lines of Credit generally have no agreed upon period of adjustment - banks increase and decrease the rate at will whenever the prime rate changes, with no notice to the customer aside from their monthly bill.
When it is time for the interest rate to adjust, banks look at the interest rate environment at the time of the adjustment. At that time, the rate can increase, decrease, or stay the same (depending on the terms of the documents you signed at closing) until the next adjustment time.
The main difficulty with ARMS is that your interest rate may end up being significantly higher than when you first closed. Banks usually put a cap on each rate adjustment, for example, a 2% cap on each adjustment would keep a rate that is at 6% (immediately before that adjustment) from going to more than 8% at that adjustment. Banks also tend to put a lifetime cap on adjustments. A typical lifetime cap might be 6%, therefore in that scenario a rate that starts at 6% at closing can never go higher than 12%.
While these caps help the borrower, they still pose risk because no one knows for certain where interest rates will be in the future. And, even though the borrower may refinance into a fixed rate mortgage if rates are high, in a high rate environment the fixed rate mortgages will be high as well.
Below is an example of how your payment might change with an ARM having a 2% per year interest rate cap and a 6% lifetime interest cap. A 30 year amortization schedule is used.
Sample loan amount: $400,000 Property Value: $500,000
Beginning rate: 6.25% Beginning monthly payment: $2,462.87 principal & interest
+ 667.00 property taxes @ $8,000/year
+ 75.00 hazard (aka homeowners') insurance @ $900.00/year
$3,204.87 beginning total monthly payment
After rate adjusts upward 2%: New rate: 8.25%
New monthly payment: $3,005.07 principal & interest
+667.00 property taxes @ $8,000/year
+ 75.00 hazard (aka homeowners') insurance @ $900.00/year
$3,747.07 total monthly payment at 2% rate increase
After rate adjusts to 4% above beginning rate: New rate: 10.25%
New monthly payment: $3,584.41 principal & interest
+ 667.00 property taxes @ $8,000/year
+ 75.00 hazard (aka homeowners') insurance @ $900.00/year
$4,326.41 total monthly payment at 4% above beginning rate
After rate adjusts to 6% above beginning rate: New Rate: 12.25%
New monthly payment: $4,191.59 principal & interest
+ 667.00 property taxes @ $8,000/year
+ 75.00 hazard (aka homeowners') insurance @ $900.00/year
$4,933.59 total monthly payment at 6% above beginning rate
So, the difference between the principal and interest payment at the beginning and at the maximum rate is: $1,728.72 per month. And, during this time, you should also expect increases to the hazard insurance premiums (aka homeowners' insurance) as well as property taxes.
Given the potential for such increases, why would anyone choose an ARM?
Reasons Some People Have Used ARM Mortgages:
Lower initial rate causes lower monthly payments, which helps them get in the property when they might not otherwise be able to do so. They intend to sell before, or soon after, the rate could adjust. They are extremely financially sophisticated and are ready, willing, and able to take the risk inherent in an ARM. They have a high net worth and/or income, and could pay off their mortgage any time they choose
Questions to Ask Yourself Before Choosing an ARM
1. At the end of the fixed rate period, will my household income be significantly higher than it is now, or should I really only expect cost of living increases at my job?
2. At the end of the fixed rate period, do I realistically expect my consumer debt to be much less than it is now? Do I have a specific plan to decrease or eliminate my credit card debt by that time? Do I have a history of spending or a history of financial discipline and saving?
3. What will be the monthly payment when the rate adjusts, assuming that it adjusts to the maximum allowable under my loan terms (generally 2 or 3% over the starting rate and 6% over the lifetime of the loan)? Can I afford this payment with the income & debt I expect to have at that time?
4. What expenses do I anticipate in the near future as well as in the next 5 to 10 years? Replacing your home's hot water heater, day care, private school tuition, and buying another car are some expenses people may anticipate.
5. Do I plan to sell this home by the time the rate adjusts, or soon after? If so, what might possibly prevent me from doing so and am I prepared to take the risk? Also, am I prepared for house values to go down?
