ARM's interest rate home loan

Adjustable Rate Mortgages, Is Now The Time?

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With the recent uptick in home loan rates, many buyers are wondering if the time is now to consider Adjustable Rate Mortgages or “ARMS”.

With interest rates off ultra low pandemic levels, some seek one last dance with unrealistically attractive mortgage rates. One emerging consideration is an Adjustable Rate Mortgage or “ARM”.

Before considering an ARM, look at today’s rates with perspective. Afterall, other than lowering your mortgage 2020-2021 rates had one other impact – they distorted a sense of normalcy.

In other words, today’s rates are still AMAZING. 30 year fixed rates were lower than today’s rates just 6 times over the past 30 years. On top of that, each of the 6 times it was by a small margin.

What Is An ARM?

Adjustable Rate Mortgages or “ARM’s” are mortgage products typically providing a lower interest rate than fixed rate mortgages. No such thing as a free lunch right? ARM’s have the lower rate for just a short pre-defined period of time. After that time, the rate can fluctuate. Alternatively, fixed rate mortgages have rates that do not move throughout the life of the loan. Below are a few more ARM basics.

Fixed Rate Period
ARM’s are based on a 30 year term. However, their interest rates remain fixed for just a small portion of that time (usually for 3, 5, 7 or 10 years). The shorter the fixed period the lower the ARM’s rate. After the fixed rate period, the interest rate on an ARM can fluctuate depending on the value of it’s index.

An ARM’s name indicates the fixed rate period’s length. For example, a 5 year ARM has a rate which remains fixed for 5 years. A 10 year ARM’s rate stays fixed for 10 years.

ARM’s Interest Rate
The rate on an ARM is based on the value of an index. ARM’s often use the COFI (Cost Of Funds Index) as their base. Lenders add a margin to the index to determine the ARM’s rate. Once the ARM’s fixed rate period expires, the rate moves according to the value of it’s index.

ARM Rate Caps
Rate Caps limit an ARM’s risk. Caps limit how high an ARM rate may increase after the fixed rate period. ARM’s have 3 different Caps:

  1. Initial Cap – how much an ARM rate can move immediately after the fixed rate period
  2. Periodic Cap – how much an ARM rate can move during each period (each ARM has an Adjustment period when the rate adjust again after the fixed rate period. 1 year or 6 months are common)
  3. Life Cap – how much an ARM rate can move in total overall

Is An ARM A Good Mortgage Option Right Now?

Over the past several years ARM’s stayed in the shadows due to a minimal difference in rate compared to fixed rate mortgages. However, as fixed mortgage rates rise many reconsider ARM’s. For the first time in a while, the difference between ARM’s and fixed rate mortgages is calculatable.

However, an ARM’s current appeal is more nostalgia than financial. Today’s ARM rates resemble the low fixed mortgage rates seen during the pandemic. However, the spread between an ARM and a fixed mortgage rate is not all that great yet. It just feels “low” like good old days of 2021.

If spreads between ARM’s and fixed mortgage rates widen, ARM’s could become a viable strategy for some to consider. One reason is that the COFI (the common index used) is a weighted average index. As a weighted average index, the index’s value increases slowly rather than overnight.

In any event, using an ARM warrants deep analysis. Reviewing ARM savings, the Caps and combining that info with the holding time of the mortgage is a good starting point. In addition, personal risk tolerance and planning for contingencies like future rate cycles are all very important details to consider.

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