Should you consider an adjustable-rate mortgage (ARM) instead of a traditional thirty-year, fixed-rate mortgage? An increasing number of homebuyers are coming to that conclusion.
For years, ARMs have been the outcasts of the housing market, blamed for many of the excesses of the housing boom and subsequent bust. Non-traditional ARMs with high-risk aspects such as abnormally low teaser rates or negative amortization left many homeowners with far greater debts than they could pay once the housing market began to collapse.
Almost a decade later, ARMs are making a bit of a comeback. Stripped of higher risk options, ARMs have settled into a more reliable and predictable mortgage product. After their plunge from 50% of the pre-crisis loan market to near zero, ARMs now hold around 5% of the market and are expected to increase significantly over the next two years.
Is an ARM right for you? It could be under certain conditions – but it's important to understand ARM terminology to make the best decision.
Many of today's adjustable-rate mortgages are hybrids, with an initial fixed rate for a certain number of years and a variable rate for the balance of the loan. The variable rate adjusts at regular intervals dictated by the loan terms.
The fixed portion of an ARM is typically anywhere from three to ten years. The initial fixed interest rate on an ARM is lower than the rate for a thirty-year fixed loan, and the shorter the ARM fixed-rate period is, the lower the interest rate will be.
ARM loan terms are typically represented by two numbers separated by a slash. For example, a 7/1 ARM has a seven-year fixed-rate period and adjusts once a year from that point forward.
The amount of adjustment is set by a floating value based on a financial index, plus a fixed-rate margin assigned by the bank at the beginning of the loan. The preferred index is usually the London Interbank Offered Rate (LIBOR), but other indices may be used. You come out ahead in the short term with an initial rate lower than a thirty-year fixed loan, and you come out ahead in the long term if the assigned margin plus the LIBOR rate at the time of adjustment is lower than the thirty-year fixed-rate loan that was available at the time of purchase.
To protect you from extremely sharp interest rate adjustments, ARMs have corresponding caps listed by three numbers such as 3/2/6. The first number represents the maximum rate increase during the first adjustment, the second number is the maximum-allowed increase in each remaining adjustment period, and the third number is the maximum amount that the interest rate can rise over the starting rate.
Because of the initially low interest rate, ARMs favor those who do not plan to stay in the home for the longer term. The payments on a $300,000 home with an initial 3.625% interest rate on an ARM would be $70 lower than a corresponding thirty-year fixed-rate loan at 4.125%. With a margin of 2.125% at adjustment, you would come out ahead with an index of 2% or less at the adjustment period – and if the index is 1.5% or less, your mortgage payments won't go up at all, as 1.5% index + 2.125% margin = the initial 3.625% interest rate.
ARMs are generally attractive in two situations: you don't intend to stay in the home for long and the difference (or "spread") between the interest rate on a thirty-year fixed loan and the initial rate on your preferred ARM is large. An ARM may still work out for a "forever home" if you can take advantage of prepayments (there are no prepayment penalties for ARMs) or you receive an extremely favorable margin.
If you are trying to decide between an ARM and a fixed-rate mortgage, investigate your loan alternatives based on your qualifications and use online calculators to run scenarios under different interest rate assumptions. In the end, your decision depends on how much risk you are willing to take for the potential reward of a lower monthly payment.
MoneyTips is happy to help you get free mortgage quotes from top lenders.