Should You Consider an ARM?

How Does an Adjustable Rate Mortgage Work?

If you are considering purchasing a home or refinancing your existing mortgage and plan on being in your property for less than 7 to 10 years, then it may make sense to consider an adjustable rate mortgage. Often referred to as ARMs, adjustable rate mortgages have initial rates which are set for a specific number of years before then adjusting up or down based upon the movements of an interest rate index which the loan are tied too. Some commonly used indexes which ARMs use include the 1 Year Treasury Constant Maturity Rate and the 1 Year LIBOR (London Interbank Offered Rate) to name a few.

When shopping for an adjustable rate mortgage, consumers should make sure that they have a firm understanding of the loan's margin, its associated index, the adjustable intervals, and the caps for the adjustments. Consumers should also be aware that the first adjustment may be potentially greater than that of future adjustments.

For example:

A mortgage professional quotes a 5/1 LIBOR ARM with a start rate of 4.250% and a 2.5% margin and a initial rate cap of 5% and then annual rate caps of 2% for every year thereafter. In this scenario the intro rate would be set at 4.250% for the first five years of the loan. On the 61st month, the loan would adjust by adding the loan's margin (2.5%) to the current index rate (say 1.5%). The result would be the "fully indexed rate" of 3.750%. In this scenario a person would actually see their rate drop after the first adjustment. Depending upon the current index rate, the loan may be limited in its first adjustment by the 5% cap limit.

Should One Consider an ARM?

Adjustable rate mortgages do carry a higher degree of risk and it is really up to consumers to determine whether the rewards outweigh the potential downside. The first step is to analyze how much lower current ARM rates are than fixed rate mortgage rates and determine how much savings there may be in the introductory rate period. Unless the adjustable rates and savings are very attractive, the borrower may want to play it safe with a fixed rate home loan product. ARM borrowers should also feel confident in their ability to refinance before their loan's first adjustment and that the real estate values in their community are in a stable or appreciating environment. The last thing a borrower wants is to be upside down on their mortgage and stuck in an ARM without the ability to refinance.