Return to ARMs (Adjustable Rate Mortgages)

ARMs or adjustable rate mortgages is making some what of a comeback. While ARMs took a beating the past few years for getting borrowers into loans with low initial teaser rates that promoted unsustainable low monthly payments. Eventually this caused borrowers financial problems who were unprepared when the adjustment period kicked in and increased the monthly payments caused defaults on loan. The key word was for unprepared borrowers, but if you know how to use an ARM it does have its advantages for certain borrowers.

Rates for 5/1 ARM are very attractive right now, as low as 4% with no points and can be even lower with some points for loans up to $729,750.

To know if should you take an adjustable rate mortgage you need to understand what exactly is an ARM. An adjustable rate mortgage have several components; some generic to the industry some specific to the loan. The generic components are:

Starting rate, this is the rate your initial monthly payments are based on. It can be as low as 1% in the past, most of those loans is no longer around.
Adjustment period, this is when the monthly payment will change based on market rate changes, for example if it is a 5/1 ARM with a starting rate of 4%, it means you will have your first payment change after 5 years.
An index, a published rate based on some industry recognized source. The most common indexes are United States treasuries and LIBOR, which stand for London interbank offering rate. Many home equity loans are based on WSJ (Wall Street Journal) prime.
A margin is what each lender adds on to the index to calculate your new monthly payment. Most margins are between 2.25% to 2.75%, each loan will have its own stated margin and the margin will be constant and never change. Today most margin are 2.25%, so in five years after the initial period has expired, your new payment will be based on whatever the index is at the time plus the margin. Many of the ARMs are using the LIBOR index. Today the 1 years LIBOR index is 1.32% assuming five tears from now the index rises to 3.32% which means rates increased by 2%, your new payment will be calculated base on 3.32% plus 2.25% for a new rate of 5.57%, not a prediction just an example. And the loan will have that rate for 1 year, the following year the same calculation is done again.

For protecting against unexpected large rate increases, ARMs have built-in rate caps. Today the most common rate caps are 5/2/5. This mean for the first adjustment period the rate can increase by no more that 5% higher than you initial rate; each year after it can increase no more than 2% higher than the previous year and for the lifetime of the loan no more than 5% of the initial rate. To be clear, if your first adjustment is 5% higher then you have capped out and it can never increase. Any future adjustments can only be lower than the 5% cap.

Shopping for ARMs is much less confusing today. The margin and index are fairly standard and the days of the past when loans with artificial low teaser rates and complicated payment options allowing borrowers to pay less than what the actual payments should be are gone. While conservative borrowers may still fear the ARMs, if your individual situation fits the parameter of an ARM, you should consider it.

The clearest example of a candidate for ARMs is someone who intends to move on to a new home after 3 or 5 or 7 years. In this case the ARM certainly offers a lower rate than the traditional fixed rate mortgages. All the variety of ARMs offered in the past probably had some feature that can benefit some borrowers, but many of the borrowers who took out the fancy ARMs did not fully understand the loans to truly benefit from them.

I am a conservative borrower and stayed away from the ARMs, but as it turned out because the rates have been so low for so long, one of my mortgages based on LIBOR have been the best loan I have had for the past 5 years.