Understanding ARMs

Adjustable Rate Mortgages (ARMs) can be intimidating to new borrowers, but should not be overlooked. The key is to understand the variables involved, and then compare them against your short/long term goals. ARM's feature an interest rate that can change and Lender's offer superior rates on ARMs compared to fixed rate loans because they are not locked into providing the exact same rate to you for the next 30 or so years. ARM's let the lender adjust according to market conditions and inflation. When interest rates go up, your ARM can go up as well.

Comparing the difference between ARM's is more complicated than fixed rate loans because the start rate is only important until the rate begins to change. How much it can change, and when it will change are just as important to consider.The period of time between when your rate can change is the first variable to consider. Some ARM's can actually change every single month, starting in the next month after you close. Ever here those 1% ads on the radio? It's likely tied to a loan that changes monthly. It's more common for an ARM to change once a year, and in many cases, it will have a period of a fixed rates for a few years before it becomes adjustable.

For instance, a 5/1 ARM is fixed at the start rate for the first five years, then adjusts yearly. A 3/1 ARM is fixed for three years, then adjusts yearly. If you are pretty confident that you are going to move again in the next five years, a 5/1 has almost no downside to it. How much your loan can adjust, once the fixed period is over, is the second variable to consider. ARM's have caps that limit how much the rate can move at one time. Let's say your caps are 2 & 5. That means the rate can adjust as much as two percent a year (assuming your loan only adjusts once a year), and can never go above 5% over your original start rate. With a 5/1 ARM and 2&5 caps, in a worse case scenario, your rate would change as follows: Year One through five would be at 6%, Year Six - 8%, Year Seven - 10%, Year Ten through 30 - 11%.

Obviously, if you plan to live in a home for the next 30 years, with no intention of ever refinancing, an ARM like this may be a bad idea. But most folks would refinance or sell by the seventh year. That's a worse case scenario. Now let's look at how the rates will actually adjust. It might seem like the start rate is the only important number to consider here, but that's a mistake. The MARGIN plays the biggest role in how much your rate can change. Margin is one of those obscure figures that many loan companies try to breeze over. Always look at the margin if you think it's possible that you'll have this mortgage once it starts adjusting. So what is margin? It's a set number that gets added to an index, to determine what your rate will be. This is where it gets tricky, but stay with me.Different ARM's are based on economical standards called indexes. One index is the Monthly Treasury Average (MTA). Another and perhaps the most popular is the London Inter-bank Offered Rate (LIBOR) and yet other loans are based on US Treasury Bills.

Essentially indexes go up and down, depending on the market. In times of higher rates, these indexes are higher. Some indexes move up and down faster than the others. Currently, LIBOR is at are about 4.75%. Here's where the margin kicks in. When your rate starts to adjust, the margin is added to whatever the index is at the time, and that is your new rate. Let's look at a 5/1 ARM and assume that your five years are up today. Lets also say that your loan has a margin is 2.375% and the Start Rate was 6% with 2&5 Caps. If the Margin is 2.375% and the current LIBOR rate is 4.75% the rate for year 6 would be 7.125% (Index + Margin).

The rate for year 7 is determined the same way, index + margin. Keep in mind that ARMs don't just go up. If the index goes lower, so do your rates. Because ARM loans typically offer lower start rates than 30 yr fixed rate loans, if used properly, they can offer a nice savings to the borrower.