Adjustable Rate Mortgages – better known as “ARMS” – instill fear into consumers hearts and minds. Truth be told, fear of ARMs is not necessarily because of one’s own experiences. Instead, the experiences of others seen from afar or read about in news articles is often to blame.
Adjustable Rate Mortgage (ARM) Breakdown
First and foremost, ARMS are not for everybody nor do they make sense in every scenario. Additionally, they add risk to your mortgage life and as such warrant a high level of extra diligence.
With that being said, certain situations are perfect for ARMS and the key is knowing when. However, even more important is having a solid understanding of how ARMS work. After-all, if you know how ARMS work you know when, where and how they can help OR hurt you.
“A” is for Adjusting
Most importantly, ARMS interest rates can adjust. The rate on an ARM is NOT fixed for the entire life of the loan. On the flip side, ARMS typically offer lower initial rates than a fixed rate home loan. However, you also assume the risk of that rate going up at some point during the life of the ARM loan.
When Will an ARM Loan Adjust
The interest rate for an ARM is fixed for a pre-determined period. A wide variety of different ARMS exist. The basic difference between ARM’s is 2 fold:
- Period of time initial rate is fixed
- The initial rate
These 2 factors are connected. Typically, the shorter the period of time the initial rate is fixed the lower the initial rate. For example, a 3 Year ARM will have a lower initial interest rate compared to a 5 Year ARM in most cases.
How Much Will an ARM Loan Adjust
While the actual amount that it WILL adjust cannot be predicted the maximum amount the ARM CAN adjust is pre-determined. The maximum an ARM interest rate can adjust is called a “CAP”. Three CAP’s govern each ARM’s max adjustment limit. They are:
- Initial Cap (max rate can adjust after fixed period)
- Period Cap (max rate can adjust during each period – typically period = 1 year)
- Lifetime Cap (max rate can adjust over life of the loan)
In conclusion, ARM’s do not make sense for everyone and certainly don’t fit every scenario. In fact, more often than not they may not be the best option. However the lower rate and payment ARM’s typically provide for anywhere from 1 to 15 years is sometimes a great tool for someone financing their home.
By Jeremy House