When you go out to shop or inquire about a mortgage, one kind you often hear about is an “Adjustable-Rate-Mortgage”, or more popularly known as ARM. For first time homebuyers, who are bombarded with new information and new terms every day, understanding how an ARM works just adds to what was already an increasingly difficult process for them. As a result, ARM, which is significantly more nuanced than the traditional fixed-rate mortgage, becomes a recipe for confusion for many borrowers. In order to get people’s business, brokers often propose it to them by sugar-coating its typically “lower” rate than its fixed-rate counterpart and many fall for it. But not everyone understands the pitfalls. Here, we try to unfold the “mystery” behind ARM and make it simpler for you to make that decision.
So what exactly is an ARM?
As the name suggests, the rate on an ARM is “Adjustable”. Unlike a fixed-rate mortgage where your interest rate is fixed throughout the term of the mortgage, in an ARM, the interest rate you pay can vary or “adjust” every year. The interest rate that one typically pays is the sum total of two rates: (1) The prevailing market rate called the “index” rate, and (2) A borrower-specific rate called “margin” rate.
Index rate is a rate that is widely published, such as the rate on a 1-Year US Treasury Bond, which is the interest rate that the US Government pays to borrow money for one year. Or it could be another rate such as the LIBOR rate (rates that the big banks charge to lend to each other).
Since a normal mortgage borrower is more likely to not pay back than the US government or a big bank, the lender asks the borrower for more interest (“margin”) to compensate it for that additional risk. So in essence, the borrower’s rate is effectively the index plus the margin. The better the credit history and income of a borrower is, the higher the likelihood of them paying them back is. In such a case, the lender is willing to charge a lower margin since the risk is lower.
The rate on an ARM “adjusts” periodically, based on a period specified at the time of origination of the loan. For most ARMs, a typical adjustment period is once a year.
What’s the biggest issue with an ARM?
The biggest worry most have with an ARM is the index rate going up with time. What that means is if that happens, one might have to make a higher monthly payment in the future than in the beginning. That is a risk and most people don’t like that kind of uncertainty. That’s the reason why a lot of people choose fixed rate mortgages. But does that mean it’s all risk with ARMs? The answer is “No”. In certain circumstances that are explained later in this article, an ARM might be a pretty good choice.
If buyers are averse to it, why do banks even bother issuing ARMs then?
Banks and other lenders offer ARMs because they like to be paid back based on prevailing rates, which is exactly what an ARM does. They bear less risk that way.
Since banks like to issue ARMs and people are averse to it, they try to make the deal sweeter for the borrower by offering the following:
• Caps Caps are a protection lenders offer to borrowers by imposing a ceiling on borrower’s interest rate. They are of two kinds:
(1) Lifetime Cap – A lifetime cap is the maximum annual interest rate a borrower will ever pay through the term of the loan. People like that because that sort of locks what their highest payment ever can be.
(2) Periodic Cap – This sets the maximum rise one can see between two successive rate adjustments.
• Lower Initial Rates To make it attractive for people to sign for an ARM, lenders often offer a low rate for the initial period. While it’s often tempting for people to sign up because of that initial low rate period, the problem with such a mortgage is that once that initial period is over, rates can go up quite a bit.
• Hybrid ARM The “hybrid” feature in an ARM is what perhaps draws people the most towards ARMs. In fact, of all the mortgages that have an “adjustable” rate, this one’s by far the most popular. The reason being that it has good features of both a fixed-rate mortgage and an ARM. The rate remains fixed for a few years and then typically adjusts once a year. The most popular types are 5/1, 7/1 and 10/1. In a 5/1 Hybrid ARM with a term of 30 years, the rate remains fixed (at a pre-specified rate) for “5” years and then changes once a year (“1”) for the next 25 years, just like a simple ARM. The fixed-rate during the first 5 year period is typically lower than the traditional 30-year mortgage, thereby reducing the borrower payment during the initial period. The risk of course is that that rate may go up once the 5-year period is over.
When is ARM a good choice?
An ARM might be a reasonable choice for you when Mortgage rates are high and affording a payment is difficult. In such a situation, getting an ARM because of its typically lower rate (than a fixed-rate mortgage), at least in the initial years, might not be a bad idea. It lowers one’s monthly payment for a few years. The biggest problem is the risk of rates going up even more after the initial period is over. That might be a big risk but still worth taking if one or more of the following is true:
• Plan to sell home before the initial period expiration – If you plan to sell the home before the initial period is over, a Hybrid ARM is virtually a fixed-rate mortgage with a lower rate than the conventional 30-year fixed.
• High-Income individuals – For those that have a substantially high income and think they can pay off the loan before the initial period expires, ARM might be a better choice. Since they expect to pay off the loan sooner, they’ll never have to deal with the risk of increased rates later and pay a lower rate.
• Reduction in other debt – If people getting a mortgage have other debt because of which affording a higher mortgage payment is difficult in the beginning, then they can go with an ARM to keep payments lower and then refinance when the other debt is paid off.
• Future Income Increase – If one expects his or her income to rise substantially in the future, Hybrid ARM is not a bad idea. So even if rates go up, there is some level of assurance of being able to make the higher future payments.
• Strong expectation of future decrease in rates – If one has strong reasons to believe that rates in the future will go down, an ARM might be a reasonable choice.
Pitfalls of an ARM
There are several things you have to keep in mind. With an ARM:
- Your monthly payment could go up significantly even if interest rates don’t go up.
- Your payments may not go down much every time interest rates go down.
- You could end up owing more money than you borrowed, even if you make all your payments on time.
- If you want to convert your ARM to a fixed-rate mortgage, you might not be able to.
Consumer Financial Protection Bureau (CFPB) has published a Consumer HandBook on ARMs to make borrowers aware of these pitfalls in much greater detail.
Do your due diligence if you get one.
For reasons listed above or otherwise, if one chooses to get an ARM, it is extremely important to understand the risks involved quite well. One should assess the possibility of his or her situation changing in the future and implications of that on the mortgage payments. If there’s any reasonable chance of that, one has to very carefully evaluate and look at the worst case scenario of having to pay the life-time cap rate.
Every one’s situation is different and so are the circumstances. If a broker or your bank recommends you to get an ARM, it is strongly advised to do your home-work, talk to counselors and other practitioners to help you make the right decision. At Stem Lending, we’ll never advise you to do something that we don’t believe is in your best interest. We don’t want anyone else to either.