Adjustable Rate Mortgages: Cutting the Pain of Interest?

When considering a home purchase, you have a wider variety of mortgage choices than ever before. One of the most asked after, and potentially misunderstood, mortgages is the Adjustable Rate Mortgage (ARM). The ARM is a mortgage option where the interest rate can increase or decrease. In contrast to typical fixed-rate mortgages, the monthly payments may vary according to agreements and lenders.

ARMS are touted as a deal for borrowers, as the average ARM rate is usually less than the average interest rate for fixed-rate mortgages. This translates to lower monthly payments. What’s not to love?

These mortgages can in fact be great deals, especially the 5/1 Adjustable Rate Mortgage, in which the ARM rate stays steady for five years. But borrowers should do some careful research and be aware of risks prior to enlisting.

First, let’s look at how ARM rates are calculated. For many typical ARMs, the lender uses a low and attractive rate in the first year to entice borrowers. For mortgages that are adjusted each year, known as 1/1 mortgages, the rate becomes tied to a publicly known index such as Treasury bills. On top of this index, the lender adds a “margin,” typically about 2.75 percent, to create a new and higher interest rate.

Under this model, an ARM that starts at 5.75 percent can increase to 7.75 percent in the second year, to 9.75 percent in the third year, and 11.75 in the fourth year. This means monthly payments will nearly double.

ARMs under the 5/1 model are much more secure. Adjustments only begin after five years. However, at that point, adjustments will commence each year, capped by the maximum two percent increase (some 5/1 ARM's are capped by the maximum of five percent on the first adjustment - be sure to ask your loan officer about this and read your Promissory Note carefully).

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Who might be good borrowers for 5/1 ARMs?

If you are looking to stay in your house for the long term, even 5/1 adjustable rate mortgages may not be appropriate. The yearly increase in rates after the initial five-year period can bring some risk into your finances that fixed-rate mortgages would not.

How do you compare adjustable rate mortgages? It’s more complex than simply comparing fixed interest rates, monthly payments, fees, and more. Instead, comparing ARMs, you need a lot more information. Consider the terms and considerations below: