Dear Dr. Don,
Can you help me to understand the pros and cons of adjustable-rate mortgages? After the ARM’s fixed period has ended (such as after one, five or seven years) and it’s time for the rate to start adjusting, is there a limit each year of how much the loan can go up, and is there a total cap of how much an ARM can go up for the life of the loan?
— Jim Rate Jump
A plain-vanilla ARM adjusts annually. When you start adding years until the first time the mortgage rate adjusts, you have what is called a hybrid ARM. Whether it’s a 3/1 (fixed for three years and then adjusting every one year), a 5/1, a 7/1 or even a 10/1, you’ve delayed that first rate adjustment. After the first rate change, the mortgage typically adjusts annually.
There are interest-only hybrid ARMs, where the monthly mortgage payment during the initial fixed-rate period covers only the loan’s interest expense.
Variables to consider with an adjustable-rate mortgage include the interest rate index that will help determine your new rate when the loan adjusts and any limitations on the size of the rate change. There can be limits on each individual rate change or on how much your rate will change over the life of the loan.
The different interest rate indexes that ARMs are based on include, but aren’t limited to, the following.
- The London Interbank Offered Rate, or Libor.
- The one-year constant maturity Treasury index, or CMT.
- The cost of funds index, or COFI.
When your loan adjusts, the new rate will be the benchmark rate from the index tracked by your loan plus a margin added to that rate, subject to any floors or caps. The floors or caps may apply per adjustment (periodic caps) or over the life of the loan (lifetime caps).
ARMs or hybrid ARMs can be the right choice for a mortgage, but you need to thoroughly understand the terms of the loan, how and when the rate resets, the base rate and margin, and the floors and caps on the rate. While there are industry conventions, the loan terms aren’t standardized across lenders, so I can’t make blanket statements about floors and caps.
With an ARM or hybrid ARM, the borrower is taking on a measure of interest rate risk from the lender. That’s why these loans can have lower interest rates than a conventional fixed-rate mortgage.
A hybrid ARM can work best when the homeowner expects to be out of the home — or the mortgage — before the interest rate adjusts for the first time. A traditional ARM would work best in an interest rate environment where short-term rates are expected to remain fairly stable, or there is the expectation that rates will decline over time.
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