Adjustable rate mortgage (ARM) loans always grow in popularity when interest rates are on the rise. Some borrowers think ARMs are the best way to save money on their mortgage in a higher rate climate. ARM loans can also be helpful for those who do not plan to stay in their home more than a few years. Whatever the reason, if you are considering an adjustable rate mortgage here are three things you need to know before signing.
1. What type of ARM are you getting?
Of course, you already know that an adjustable rate mortgage means that eventually your loan interest rate can adjust higher or lower, but there are many different types of ARMs and it is essential to know when your loan will start adjusting. There are 3/1 ARMs, 5/1 ARMs, 7/1ARMs and 10/1 ARMs.
The first number in the loan title refers to the fixed rate period at the beginning of the mortgage. So a 5/1 ARM, for example, indicates that the low, initial interest rate will not change for the first five years of the loan. The “1” in those ARM loan titles means that after the introductory rate period, the interest rate on the ARM loan can change once year thereafter. Typically, your initial rate will be higher the longer your introductory fixed rate period is.
2. What are the rate caps?
The terms of your ARM loan will include interest rate caps, meaning a ceiling to how high your rate can climb. Lenders will choose a common financial index and add a margin to it to determine your interest rate. For example, your margin may be 2.5%. If the index is currently at 2%, your interest rate would be 4.5%.
When the rate begins to adjust there is an initial rate cap that says your rate can only increase by so much for that first time. This is to make sure any increase is not so significant that you can no longer pay your monthly bill. The initial rate caps are commonly either 2% or 5%. So, if your first rate was 4.5% and your rate cap is 2%, your first adjustment rate could not be more than 6.5%, regardless of how much the index has risen.
There is also a subsequent rate cap with most ARMs that stipulates how much the rate can rise during the following adjustment. This is often 2%. And all ARMs include a lifetime rate cap which is the maximum percentage that your rate can change at any time during the life of your loan – often 5%.
3. Which index is associated with your ARM loan?
Every ARM loan is tied to a commonly used financial index in order to move according to general economic trends. The most common indices are the one-year LIBOR (London Interbank Offered Rate), the weekly yield on the one-year Treasury bond, the COFI (11th District Cost of Funds index) and the CST (Constant Maturity Treasury.) While they all move at roughly the same pace as current economic conditions, it is important to know the one to which you should be paying most attention.
Smart and savvy home buyers can make ARM loans work to their financial advantage if understand the essential about their adjustable rate mortgages. Borrowers should make sure they can afford their loan payments even at the highest interest rate caps. This will help reduce the risk of ARM loans.
An Adjustable Rate Mortgage isn't for every one or every situation, give Minnesota Residential Mortgage, Inc. a call today at 651-797-4090 . One of our experienced loan officers can help you decide if an ARM loan would be right for your particular situation.