An adjustable rate mortgage (ARM) is a mortgage where the rate can periodically be adjusted, up or down, along with the payment.
All ARM’s have a period where the interest rate is fixed (the starting rate) at the beginning of the repayment period. This fixed rate period can be 3, 5, 7 or 10 years on conforming loans (Fannie Mar or Freddie Mac). The shorter the fixed rate period, the lower the initial interest rate and the payment.
The principle and interest payment (P&I) on these loans remains the same throughout the fixed period. After that the rate can adjust up or down according to the index used and the margin for that loan.
All ARMs will have a designation such as 5/2/5. The first number is the maximum amount that the loan interest rate can go up at the end of the initial fixed rate period. In a 5/2/5 ARM, it would be 5 points. The second number is the maximum adjustment to the rate allowed in each subsequent adjustment period. In this example, it would be 2 points. The third number is the maximum amount that the rate can adjust to over the initial start rate during the life of the loan.
How is the new rate determined at the end of the fixed period?
Most ARMS use either the one year Treasury bill (T-bill) or the LIBOR interest rate as the index, at the start of a new adjustment period. To this index the margin is added (I+M). This I+M is then compared to the current interest rate of the loan. If the current rate is lower than the I+M, the new rate will increase up to the maximum allowed per year. If the current interest rate is higher than the I+M, the new rate will drop by the maximum amount allowed per year.
However, at the first allowed adjustment (the end of the fixed rate period), the rate can adjust up to the maximum amount allowed all at once.
Example: Consider a 7 year 5/2/5 ARM with a start rate of 3.5% and the one year Treasury bill as the index.
The rate will remain fixed for the first 7 years at 3.5%
If at the end of the initial 7 years, the one year T-bill rate (the index -I) has risen to 9%, the loan interest rate will increase to 8.5% (I+M =9% but the start rate + max allowed margin, is 3.5%+5%=8.5%). The rate cannot increase above this rate in future years but may come down if the index falls.
If at the end of the initial 7 years, the T-bill rate is only 2%, the interest rate for the next year becomes 4% (I+M= 2%+2%=4%).
With each subsequent year the maximum rate can only rise or fall by 2% within the max allowable of 5%.
Should I go with a fixed rate or an adjustable rate mortgage?
You must look into your crystal ball. Will your family be growing and need more room, or will your children move out and you want to downsize? Is this a “starter” home for you? Will you want to relocate to a better school district as your children get older? Is there a chance you may be relocated by your employer or change jobs that would require you to move to a different city?
If you feel that you will be moving or relocating in the next 3-10 years, or if you feel interest rates may drop, an ARM may be right for you. You will save a significant amount of money if you are correct. Over the last 10 years, people that chose an adjustable rate mortgage have benefited greatly.
On the other hand, current rates are near their historic lows – both for ARMs and fixed rate mortgages. Some financial advisors think rates will only go higher. Many people don’t want the stress of having the prospect of their house payment increasing dramatically if they are still in the same house and don’t wish to move.
At First Nations Home Mortgage we have counseled many borrowers about the pros and cons of adjustable rate mortgages for their unique situations. Let us help to provide the information you need to make your decision. Give us a call Today!