Here are seven questions to understand ARMS which you should ask your lender. If you’re shopping for a mortgage, you need to decide whether to choose one with a fixed or adjustable interest rate. Last year ajustable rate mortgages only accounted for 4% of mortgages in the US, but now they are as much as 10% of mortgages – a real reflection of the higher interest rates. Clearly, lots of buyers think the ARM Is a good option for home purchases in this market.

ARMS Can Be Good in Some Circumstances

Six Questions to Understand ARMSAn adjustable-rate mortgage, or ARM, might be a good idea if you’re only planning to stay in your home for a defined number of years, but you need to ask these six questions to understand ARMS and read the fine print first. You might be surprised by increased payments and changed circumstances if you don’t understand the terms clearly.  Keep reading to understand the difference between a fixed rate and an adjustable rate mortgage.

A 5/1 ARM means the mortgage has its initial fixed rate for the first five years and then the rate can adjust once per year for the remaining 25 years. Other common options include a 7/1 or 10/1 ARM, meaning your initial rate is fixed for 7 or 10 years before it can adjust.

So you could save a small fortune in monthly payments by opting for an ARM, at least over the first five to 10 years of your loan. Alternatively, you could afford a much nicer, more costly home with the same payments you’d make on a smaller, fixed-rate mortgage.

Of course, an ARM isn’t for everyone. If you plan to stay in your home longer than 10 years, an ARM might not be the best choice. But if an adjustable-rate loan works for your financial situation, you could have a much better shot at affording a home in today’s market.  In addition, you can always finance out of your ARM and into a fixed rate mortgage when rates return to a level that is more acceptable to you.

Protections in Adjustable Rate Mortgages

Each lender sets its own terms and conditions for adjustable-rate mortgages, so you’ll have to check your loan agreement for specifics. But ARMs today commonly offer three types of rate caps that protect borrowers from unreasonable rate hikes. Most ARMs have:

1. A cap on how much your rate can increase at the end of the fixed-rate period. It can’t exceed the cap, no matter how high interest rates have risen.

2. Another cap on subsequent annual adjustments, meaning your rate can only increase by a certain amount each year.

3. A third cap on how high your rate can go over the entire life of your mortgage. This protects homeowners from seeing their rates rise astronomically if the market takes a dramatic upswing.

Seven Questions to Understand ARMS

1. How is the rate determined? After the initial repayment period ARM rates are based on a benchmark market index plus a set rate known as the margin.  For example, when I had my adjustable rate mortgage, the rate was set according to the one year T Bill rate plus an additional amount, which is my case was 1.5%.  For example, if the 1 year T Bill rate was 3%, then my mortgage rate was 4.5%.

2. How volatile is that index?  The 1 year T Bill rate was pretty stable, but not every index is slow moving.  Ask your lender to review the history of the index to which you are going to be tied.

3. How long is your rate fixed before it starts to adjust?  In my case it was fixed for 7 years before it could begin adjusting.  A lot can happen to rates in 7 years.  In my case rates started going down and so did my mortgage rate when the time came to adjust.  I got down below 2% one year!

4, What is the lifetime cap and the annual cap on your mortgage.  For example, in my case, the cap was 6% for the lifetime cap and 2% for the annual cap.  I got my mortgage in 2003 when fixed rates were very high and my initial rate was 8.5%.  The lifetime cap was 6% so that meant that the mortgage rate could go up to 14.5%.  Yes that was scary, but it could not happen for 10 years.  The rate was fixed at 8.5% for 7 years and then it could not go up higher than 10.5% in the 8th year, 12.5% in the 9th year and 14.5% in the 10th year.  I was willing to take a chance that the interest rates would get better before that and I could refinance before that.

5. Is there a floor on how low your mortgage can go?  You should always be optimistic and interest rates will come down again!

6. Is there any possibility of negative amortization. Many people have gotten into trouble with ARMs because of negative amortization. That happens when the amount of payments made is not enough to cover interest. The amount of unpaid interest is added to the loan, and then interest is charged on that. This means the total balance on the mortgage can actually increase, even if you make payments on time every month. RUN AWAY from an ARM if negative amortization is possible.

7. Is there a prepayment penalty?  You might have to pay thousands of dollars if you decide to sell your house or refinance your mortgage before the fixed period ends.

View All Buying Posts