Today’s mortgage interest rate environment is without question the lowest it has been in decades. So why would anyone want to take an ARM (adjustable rate mortgage) instead of a fixed rate?
First off, let’s talk about how adjustable rate mortgages work. Most ARMs are spread over 30 years, just like a 30-year fixed-rate mortgage (a mortage where the interest rate never changes, by the way). The most common ARMs are the 3/1, 5/1, and 7/1 Treasury or Libor ARM. What this means is that the rate will stay fixed for 3, 5 or 7 years respectively and then will turn into a series of one-year adjustable mortgages.
For example, a 5/1 ARM would stay fixed for the first 5 years, and in years 6 to 30, the rate would adjust once a year on the anniversary date of the loan. The rate is calculated based upon an index (Treasury or 12-month Libor are the most common) plus a margin (the banks profit) to arrive at the final rate. The Treasury rates are based on the one-year Treasury rate that is sold by the United States government and the LIBOR, or London Interbank Overnight Rate, is the rate that banks use among themselves.
Calculating the rate is simple. Let’s say the Libor rate is at 1 percent and the margin is 2.25 percent, then the rate for that upcoming year would be 3.25 percent. ARMs also have caps as to how high the rate can go per adjustment and how high the rate can go over the life of the loan. Usually, the first cannot go more that 5 percent over the start rate. Every year after that, the rate cannot move more than 2 percent and the lifetime cap is also 5 percent. So the caps you will usually see on an ARM are 5/2/5. So should the rate go up 4 percent on the initial adjustment the max that it could go up the following year would be 1 percent. The rate can never go higher than the max cap rate.
So why in the world would anyone want to incur that kind of risk? ARMs usually carry a lower rate than fixed-rate products, and are a great product if you will be selling your property or paying off the mortgage prior to an adjustment. For example, a newlywed couple should consider a 5/1 or 7/1 ARM if they are buying a one-bedroom condo and are planning on starting a family down the line. This would mean that their needs will most likely change prior to the 5 or 7 years, prompting them to sell and upgrade to a bigger property. They would not experience the risk of the adjustment.
Another group of borrowers that should consider the adjustable rate are baby boomers who will be selling their homes after they retire to downsize. Again, they would probably sell prior to the adjustment period, which would allow them to save money month after month while they are waiting to retire and not risk of the rate going up if they sold prior to the adjustment.
I am a big advocate for fixed rate loans, but if the scenario is right, an adjustable rate can save money and carry little risk.
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