Is an ARM right for you?
by Tom Levine
Published on this site: July 17th, 2004
Lets start by taking a look at 7 key elements of an adjustable
rate mortgage:
- ARM defined: While a fixed rate loan is constant and never
changes throughout the life of the loan, an adjustable rate mortgage
changes periodically. The interest rate of an ARM goes up and
down based on whatever external index it is tied to. Add the lenders
margin to that, and youve got the rate. Add
costs to that, and youve got the APR.
Other considerations include the fixed period, the adjustment
date, and the adjustment interval. There are built in risk management
devices such as caps, conversion clauses, rate ceilings, rate
floors, periodic payment caps, and periodic rate caps.
So, while fixed rate loans stay constant and are fairly straightforward,
future payments on ARMS is an unknown, and they go up and down
depending on a variety of variables.
- Index: An adjustable rate mortgage is tied to an external index.
If you look in the financial section of the paper today, you might
see a chart posted for the 1 year constant maturity treasury index,
also called the CMT, otherwise known as the 1-year T-bills.
You might see a graph, showing the T-Bills rising and falling
in value over time.
About 50% of all ARM loans are tied to the 1 year T-Bills. If
this is the index used on your loan, then your house payment will
rise and fall alongside the T-Bill index (basically).
This is just one example of an index used for ARMs. There are
indeed several, and some are more volatile than others. The point
is that if that index goes up, the ARM can go up. If that index
goes down, the ARM can go down.
- Margin: Lenders add a specific percentage to the index.
This is called margin. Put another way, the adjustable
rate equals the interest rate tied to the index plus the lenders
margin. For example, if the T-bills are going for 1.5%, and the
margin is 2.5%, then the ARM interest rate is basically 4%.
Whats important to know is that different lenders charge
different margin, and margin is different from one index to the
next. So, just because the margin is cheaper on an ARM tied to
T-bills, doesnt necessarily mean its the best deal.
What if the interest rate on a different index, say the LIBOR,
is lower? Maybe the margin is higher? Keep your eyes open, and
compare the combination of both margin and index, when looking
to compare ARMs.
- Fixed Period: The terms of the loan typically begins with a
fixed period of anywhere from 1 month to 5 years or more, where
the rate is not adjusted and stays constant (like a fixed rate
loan). A 1 month ARM, for example, has a starting fixed period
of 1 month, whereas a 1 year ARM has a starting fixed period of
1 year.
- Adjustment Interval: After the fixed period has elapsed, then
there will be an adjustment date in which the rate is modified
to conform to the index within the terms of the loan. This interval
is typically 1 year, 3 years, and 5 years, but a wide variety
of intervals exists.
In other words, you start with a fixed period and the rate is
fixed. Then you get to the adjustment date, and the rate goes
up or down depending on the index and the terms of the loan. Then
you go into the adjustment period, lets say the interval
is 1 year, so for 1 year the rate stays the same.
Then you get to the next adjustment date, and the whole process
repeats itself.
- Caps: There are built in devices to the ARM that helps manage
the risk. For example, most loans incorporate an interest rate
ceiling into their terms. The interest rate charged can never
exceed the agreed upon ceiling. There is also usually a corresponding
interest rate floor (the rate can never drop below this). There
is usually a periodic rate cap, that limits the amount the rate
can go up or down (during the adjustment period), irrespective
of the index. There may be more in the terms of your loan worth
exploring, but the important point here is that Caps help control
risk. They make the ARM manageable.
- Conversion Clause: What if 5 years go by, and the rates are
still low, and now youre fairly certain youll be living
in your home for the next 10 years. In this instance, it might
be wise to switch over from an ARM to a fixed rate. Many loans
contain a conversion clause allowing you to convert the loan to
a fixed rate mortgage. There is sometimes a fee associated with
this provision. Also, the terms of the conversion clause may require
a period of time to elapse before it becomes available.
So, is an ARM is right for you?
Of course, thats a question that only you can decide. However,
here a few possibilities:
- Buying Power: - Adjustable Rate Mortgages, in the right market,
can allow buyers to purchase higher valued homes with a lower,
initial, monthly payment.
- Short Term Home Ownership: - The average home owner lives in
one residence 7 to 8 years (not 30 years). Do you know how long
youll be there? If you have confidence that youre
only there for the short term, then an ARM could save you money.
- Risk versus Reward: - What is your level of comfort with risk
and how prepared are you to adjust your finances accordingly?
If rates stay steady or decline over the long term, an ARM could
offer you the greatest possible savings.
Needless to say, a word of caution is appropriate here. Lets
not forget the tried and true warhorse of the fixed rate loan. Fixed
rate offers the least amount of risk to the borrower over the long
term. There are many unknowns, many variables, and many terms and
conditions that need to be considered when looking into an ARM.
The best place to start is always to evaluate fixed rate loans,
as a benchmark, and then branch out your options from there. Know
the current rates and get a feel for the trend. Compare
several loan offers before signing on the bottom line, and explore
all the variables that go into these loans, including the 7 mentioned
in this article. Talk to 3 or 4 lenders during this process, to
see who you like doing business with. Above all, dont just
fixate on the monthly payment. Shop rate, and review the terms of
the loan offers. We provide a free rate-watch at our website, along
with a directory of lenders and resources, or you can go to any
search engine on the internet and find other useful sites and tools
out there.
Weve enjoyed providing this information to you, and we wish
you the best of luck in your pursuits. Remember to always seek out
good advice from those you trust, and never turn your back on your
own common sense.
Sincerely, Tom Levine
[email protected]
http://loanresources.net
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Copyright 2004, by LoanResources.Net
Tom Levine provides a solid, common sense approach to solving
problems and answering questions relating to consumer loan products.
His website seeks to provide free online resources for the consumer,
including rate-watch, tips and articles, financial communication,
news, and links to products and services. You can check out Tom's
website here: http://loanresources.net
, or you can email Tom at [email protected].
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