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Looking to own a property for just a few years? An ARM can save you money.
What Is an ARM?
An ARM is an adjustable rate mortgage. An adjustable rate mortgage lives up to its name because the interest rate you pay on the loan can change, unlike a fixed rate mortgage that has an interest rate that remains the same for the duration of the loan. Because your interest rate can go either up or down, so can your monthly payments.
Parts of an ARM
To really understand what an adjustable rate mortgage is all about, you need to know at least a little about an ARM's main components: an initial rate period, an adjustment period, an index rate, a margin, and an interest rate cap.
Initial Rate Period - The interest rate your ARM carries at the beginning of the life of the loan is the initial rate period. Depending on the kind of ARM you have, the initial period can be as short as a month or as long as a year. Be very wary of any extremely low interest opening teaser periods. Like credit cards with a low initial interest rate, the rate following the initial period is likely to be much higher.
Adjustment Period - Because the interest rate on any ARM is going to change, you need to have some determination of how often the rate can change. The adjustment period is the length of time the interest rate will stay the same. The rate is reset at the end of each adjustment period, and your monthly payment is recalculated.
Index Rate - The interest rate on all adjustable rate mortgages is linked to some kind of economic index rate, which is used as a guide to determine interest rate changes. Though there are many kinds of indices, most mortgage lenders base their ARM rates on one-, three-, or five-year Treasury securities.
Since different lenders use different indexes, it's important to shop around. You want an ARM that is linked to an index that has remained fairly stable over many years. So, don't be shy to ask lenders how each index used has performed in the past.
Margin - Lenders do not simply earn a profit through the interest rate that's tied to an economic index. They add percentage points, called the margin, to the index rate. The margin plus the index rate determine the ARM's interest rate. Another important reason to shop around is that different lenders have different margins. To find the smallest margin, ask lenders what margin they are adding to the index.
Interest Rate Cap - There's a possibility that the interest rate of an economic index can climb higher and higher. If the interest rate on your adjustable rate mortgage is tied to a rising index rate, your interest rate and your monthly payment will go up, too. To keep your rate from reaching altitudes where there is no air to breathe, an interest rate cap is determined at the beginning of the loan process.
There are annual rate caps and life-of-the-loan rate caps. The annual cap limits the amount your interest rate can change, up or down, in any year. The life-of-the-loan cap limits the amount your interest rate can change, again up or down, for as long as you have the mortgage.
Types of ARMs
Adjustable rate mortgages have plenty of details to carefully consider. To make ARMs even more complicated, there are a few different kinds of ARMs.
Hybrid ARMs - Hybrid ARMs are a combination of fixed rate and adjuatable rate mortgages. These hybrid ARMs have an interest rate that is fixed for the initial rate period, that then changes over the adjustment rate periods. Hybrid ARMs are described with pairs of numbers such as 1-1, 3-1, or 5-1. The first number refers to the fixed rate period and the second number refers to adjustment rate periods. For example, a 5-1 hybrid arm has a five year fixed interest rate period followed by one year adjustment rate periods.
Interest-Only ARMs - Interest-only ARMs have payment plans where you only pay the interest on the loan for a specified number of years, often 3 to 10 years. Naturally the monthly payments will be smaller during his period because no money is going to reduce the principle. After the interest-only period, your monthly payments will increase because paying down the principle is included with the interest each month. Be aware that for some interest-only ARMs, the interest rate of the loan can adjust during the interest-only period.
Option ARMs - Also called payment option or pick-a-payment ARMs, option ARMs are adjustable rate mortgages that allow you to choose from several payment options. Though the options can be many, they usually include:
- A traditional payment of principal and interest. This option reduces the amount you owe on your mortgage. These payments are based on loan terms, such as a 15- or 30-year payment schedule.
- An interest-only payment. This option pays the interest but does not reduce the amount you owe on your mortgage as you make your payments.
- A minimum (or limited) payment. This option may be less than the amount of interest due that month and may not reduce the amount you owe on your mortgage. Choosing this option, means that the amount of any interest you do not pay will be added to the principal of the loan. When unpaid interest is added to the principle, the amount you owe increases, future monthly payments increase, and the amount of interest over the life of the loan increases.
All of these options are clearly best suited for very short-term ownership of the property. If you are considering an option ARM, do not let the teaser rate or initial payment amounts determine your decision. Evaluate the details of the index and the size of the margin. Understand that long-term interest rates go up and that the value of the property may not go up and may even go down.
Stay Away from Negative Amortization
With the minimum payment option described above, negative amortization is a very possible outcome. Basically, negative amortization occurs when your mortgage balance increases instead of decreases. This increase of debt happens when your monthly payments do not cover the cost of interest. The unpaid amount is added to the principle, also growing the amount of interest due. With this situation, it's possible for you to make your required monthly payments, but actually owe more later in the life of the loan than at the beginning.
Why Choose an ARM?
With the uncertainty of interest rates, why choose an adjustable rate mortgage over a fixed rate mortgage? Naturally it all boils down to the possibility of saving money.
The interest rate for the initial period of the ARM is almost always lower than any current interest rate of a fixed rate mortgage. And it's possible that an ARM could be less expensive than a fixed rate loan over a longer period of time if interest rates go down.
Though you could save money, that possibility comes with real risk. To reduce your risk, and to increase your odds of saving money, consider an ARM if:
- You strongly believe that you will own your home for only a few years, or even better, less than the initial period of the loan.
- You expect your income to increase in the near future to cover the likely rise in interest rates.
- The current interest rate for a fixed rate mortgage has risen to what must surely be the upper end of a bubble and will very likely come down.
Otherwise, you are probably better off with a standard fixed-rate mortgage.
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