An adjustable-rate mortgage (or ARM) is simply a loan program that features a variable interest rate. The rate changes and adjusts to an indicator of changes in market known as a rate index. There can be periodic rate adjustments, making the monthly payments rise or fall every few years after the first adjustment.
Hybrid ARMs are the most popular type, combining the benefits of fixed-rate as well as adjustable-rate mortgages.
How an ARM Works?
You need to know the basic features of an adjustable mortgage before you will be able to understand how it works.
Here is an example
A 5/1 ARM means a loan with an initial-rate period of 5 years, upon the expiration of which the rate is subject to annual adjustment. Assume that the initial rate is 3.25% and the margin is 2.25%. The index at the time of first adjustment is 4.25% and the caps applicable to your loan are represented by 3/2/6.
Your monthly payment will be based on the interest rate of 3.25% for the first five years of loan. Your rate begins to adjust after the first five years of fixed-rate period. If there is no cap, the applicable rate will become 6.5% (4.25%+2.25%), which is a sum total of index and margin. This is called the fully indexed rate.
If there is a cap, such as the initial cap of 3%, the adjusted rate at the end of five years can’t be more than 6.25% (3.25%+3%), the sum of initial rate and initial cap, which is just 0.25% short of the fully indexed rate. The fully indexed rate can only be possible at the next adjustment provided there is no change in the rate index.
Analyzing an ARM
To perform an analysis whether or not an ARM is a better option for you, the information about the following must be had from the lender.
Advantages and Disadvantages of ARM
With an ARM, you may be able to buy a bigger house at a lower cost. The rate of interest is much lower than most conventional mortgages, at least in the initial few years, allowing you to afford a house even if you are not earning much.
You can expect your income to grow and afford increased payments in future. An ARM is typically the best option for a homebuyer who doesn’t intend to live in the house for a long time and sell it well before the rate begins to adjust.
The loan becomes risky when it enters the rate adjustment period. Be prepared for a payment shock if you have not anticipated the uncertainty of a rate index or a much higher payment when the rate begins to adjust.
The interest rate and payment caps may be there to protect you, but you may face another problem when you end up having more loan balance that you originally borrowed. This situation is called negative amortization.