There are many reasons borrowers look to an adjustable rate mortgage (ARM) rather than a fixed rate mortgage. For starters, the interest rate is often lower during the first few years because ARM loans have ‘teaser rates.’ Other borrowers need the ARM in order to qualify for the loan because their debt ratio is too high for a fixed rate loan.
No matter the reason that you need/want an ARM loan, you should know how they work so that you can get the most out of your mortgage.
The ARM Basics
There are two factors that affect how your interest rate changes after the introductory period. For example, if you have a 3/1 ARM, you don’t have to worry about these factors until after the first three years of the loan. After that point, your interest rate will change annually based on the index and the margin.
The ARM Index
The ARM index is a market index of the lender’s choosing. The named index never changes, but its value will change often. The most common indexes used by lenders include:
- Prime rate
Your lender must disclose which index they choose for your loan. While you can’t predict how the index will perform in the future, at the very least, you can look at how it performed in the past by looking at its historical patterns.
The next factor is the margin. This number the lender does have control over. It’s not a fluid number, though. Once the lender determines the margin for your loan, it remains that number for the life of the loan. This is one factor that you can shop lenders for, as each lender may have its own margin. You obviously benefit from the lower margins, so shopping around can work to your benefit.
The ARM Caps
Luckily, each ARM loan has caps or a maximum amount it can adjust at any given point. This can help you figure out the ‘worst case scenario’ should your rate adjust. The caps are as follows:
- Initial cap – This cap limits how much your interest rate can change during your first adjustment period.
- Periodic cap – This cap limits how much your interest rate can change after the first adjustment and for every adjustment afterwards. On average, lenders allow your interest rate to change as much as 2% per period, but this can vary by lender.
- Lifetime cap – This cap limits how much your interest rate can change over its lifetime. If your interest rate hits this cap, it cannot go any higher, no matter how much time is left on your loan. On average, lenders make the lifetime cap 5%.
When you look at ARM loans, don’t focus on the index or the initial interest rate alone. Instead, focus on the big picture. How much is the margin? How much can the rate change during the first year? How much can it change over the life of the loan? Knowing these answers can help you make a solid decision regarding which ARM loan is best for you.