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This may seem an odd time to consider an adjustable rate mortgage (ARM). After all, in a recent post, we discussed fixed rate mortgages are near all-time lows. Why not lock in the low rate? Overall, we agree with this philosophy, but there are a couple of reasons an ARM may be right choice currently and down the road.
What is an ARM?
Most people are familiar with fixed rate mortgages. Indeed, the 30 year variety is the most popular type of mortgage. It provides security, since the rate will not change over the life of the loan, even if rates spike dramatically upward. Still, this comes at a price, in the form of a higher interest rate.
An ARM has a floating rate. It is usually tied to an index, such as LIBOR or the one year Treasury rate. There are a lot of varieties (even setting aside interest only ARMs in which the borrower does not pay any principal of a period of time), and it is even more important to read and understand the terms before you undertake borrowing such a large sum.
Terms you should know
You will often see an ARM quoted as 3/1, 5/1, 7/1, 10/1, although there are different varieties The first number represents how long the initial rate will be in place. In a 5/1 ARM, this introductory rate, typically lower than a fixed rate, will not change for five years. The second number indicates how often the rate is adjusted, which is annually in this case.
You will next need to understand the index it is based on. We mentioned two above – LIBOR and the Treasury rate. There will be a margin added to this rate after the initial period expires, which you will also need know.
There are three more very important concepts: initial cap, periodic cap, and lifetime cap. As the names suggest, these put limits on how much your rate can go up. The initial cap is how much the mortgage rate can increase at the time of the first adjustment (e.g. in a 5/1 ARM, it would cap the amount the new rate can rise after five years.) The periodic cap limits the increase for each subsequent time it can be adjusted, while the lifetime cap sets the maximum amount the interest rate can be increased over the life of the loan.
These are important to understand in order to properly compare different ARMs. Unlike a fixed rate mortgage, an equal initial rate between lenders can have very different consequences down the road.
Is this right for me?
This could be, if you plan on staying in the house for only a few years. You will have monthly savings from the lower initial rate, and, if you move before the adjustment period expires, you will avoid the risk of higher payments down the road. Even if you wind up staying, you may not face a payment shock if your caps are low enough.
Of course, if you are not in the market for a new home right now and long-term interest rates rise, the savings an ARM compared to a fixed rate could be even more significant.
It is especially important to do your homework and understand how high your rate can go. The Federal Reserve held short term interest rates near 0%, and may hold off for the rest of the year. If that’s the case, your adjustable rate will likely not adjust upward for several months.