Adjustable Rate Mortgages(ARM) are Still Here! Part 2

Part 1:  Adjustable Mortgage Rates (ARM) a re still here | Part 2

Here are some questions you need to consider:

How long do I plan to own this home? (If you plan to sell soon, rising current mortgage rates may not pose the problem they do if you plan to own the house for a long time.)  It is my opinion this should be the number 1 factor when considering if an ARM is right for you

Is my income enough—or likely to rise enough—to cover higher mortgage payments if current mortgage rates go up?

Will I be taking on other sizable debts, such as a loan for a car or school tuition, in the near future?

Do I plan to make any additional payments or pay the loan off early?  I strongly suggest everyone should attempt to make additional principle payments as often as possible.

How ARMs work?

The initial rate and payment amount on an adjustable rate mortgage will remain in effect for a limited period—ranging from just 1 month to 3 years, 5 years , 7 years and 10 years. If you think an adjustable rate mortgage will work for you I would not consider any term less than a 3 year arm.

If lenders or brokers quote the initial rate and payment on a loan, ask them for the Annual Percentage Rate (APR). If the APR is significantly higher than the initial rate, then it is likely that your rate and payments will be a lot higher when the loan adjusts, even if general interest rates remain the same.

There are 4 vital components to an adjustable rate mortgage:

1. The adjustment period. This is when the interest rate on your loan will adjust. For illustration purposes we I will use a 5/1 adjustable rate mortgage and a 5/6 adjustable rate mortgage.  The first number is the number of years your initial interest rate on your mortgage will be fixed for.  In the case of the 5/1, the initial interest rate will be fixed for the first five years (60 months and will  adjust every 1 year afterwards.

5/6 again the initial interest rate will be fixed fir the first five years but then the rate could adjust every 6 months thereafter.The interest rate on an ARM is made up of two parts: the Index and the Margin, which are the 2nd and 3rd vital components.

The index is a measure of interest rates generally, and the margin is an extra amount that the lender adds to the index when calculating your interest rate.  Lenders base ARM rates on a variety of indexes. Among the most common indexes are, the London Interbank Offered Rate (LIBOR) and the the rates on 1-year constant-maturity Treasury (CMT) securities.  Today the Libor index is at 1.39 which most agency loans are base on and the Treasury Index is at .47 which most FHA loans are based on. The margin can vary per loan program but generally are 1.75 -2.00 for FHA loans and 2.25% -2.75% for Agency Fannie Mae and Freddie Mac loans

The forth vital component of an adjustable rate mortgage are the “caps” This is the amount your interest rate may adjust at each adjustment period.  The most common caps are 1/1/5 for FHA and 2/2/5 or 5/2/5 Agency loans 2/2/5 or 5/2/5.

The first number is the maximum % your rate can adjust upon the first adjustment period, the 2nd number is the maximum % the rate can adjust at each subsequent adjustment period and the 3rd number is the maximum % the interest rate can adjust over the life of your loan.  So a 5/1  adjustable rate mortgage based on the LIBOR index with caps of 2/2/5 may adjust up to 2% after 5 years on the 61st payment, then every year (12 payments) there after may adjust another 2%  and may adjust a maximum of 5%.  PLEASE NOTE the adjustments may be adjusted either up or down.  Today’s libor index is 1.39 so if the margin is 2.25 based on the Libor index and your adjustable rate adjusted today then the rate would be 1.39 + 2.25 = 3.64. (Please remember today’s current mortgage rates are still at historically low levels and will probably not stay here forever)

Most people have a tendency to consider if an adjustable rate mortgage is the right loan program for them based on the initial fixed rate loan term. When comparing an adjustable rate mortgage to a 30 year fixed rate mortgage  For instance if they are planning on moving within the next 5 years then a 5 year adjustable rate mortgage would be more beneficial for them, if they plan on moving in 7 years then a 7 year adjustable rate mortgage would be more beneficial than a 30 year fixed rate mortgage.

The following comparison will show you how a 5/1 adjustable rate mortgage with a margin of 2.25 and caps of 2/2/5 @ 3.875% interest rate will take you more than 7 years to catch up to what you would have paid on a 30 year fixed rate mortgage at 5.00 interest rate assuming the adjustable rate mortgage adjust at the maximum allowed at each adjustment period.

Comparison of ARM and Fixed Rate Mortgage

As you can see in the example above you will save @ 12k after 5 years, @10k after 6 years and @ 5k after 7 years by having a 5/1 adjustable rate mortgage instead of a 30 year fixed rate mortgage.

At the end of the day you have to feel comfortable with the decision you make.  I wanted to open your eyes to some facets of an Adjustable Rate Mortgage you may not have been aware of.  Call one of our experienced mortgage professionals at Total Mortgage Services to discuss which loan program would best suit your individual needs.