If home prices, property taxes, and mortgage rates are on the rise, an adjustable rate mortgage (ARM) can initially make monthly payments easier to afford. Approximately 10% of homebuyers are using ARMs, compared to 5% a few years ago.
Although ARMs may offer a lower monthly payment than a fixed rate mortgage for a period of time, an ARM isn’t for everyone. The amount you pay each month may eventually go up, and you don’t want to be stuck with an ARM when rates are on the rise.
This article explains in detail what an ARM is, examples of ARMs, how they compare to a fixed rate mortgage, and how to decide if an ARM is right for you.
What is an ARM?
“ARM” stands for “adjustable rate mortgage.” It’s a home loan where the interest rate is fixed for a set period of time. After that set period of time, the rate resets based on the benchmark/index plus an ARM margin. This continues for the life of the loan or until you refinance the mortgage. All ARMs are based on a 30-year mortgage.
You’ll see ARMs in a number of different forms. For example, in a 7/1 ARM, the rate is fixed for the first 7 years. After that, the rate is reset every year (the 1). Depending on the type of ARM you select, your rate may change during its adjustable period. This could be monthly, quarterly, annually, every three years, or every five years. The frequency of your adjustments will be disclosed in your loan program. The first number represents the period of time the rate is fixed. The second number indicates how often the rate will be adjusted after the fixed period.
At NewCastle Home Loans, we offer 5/1, 7/1, and 10/1 ARMs.
What exactly happens after the fixed rate period?
After the set period of time, the interest rate can increase or decrease based on the index plus a set margin. The margin is usually around 2-2.5%. This is added to the index to determine the rate.
The adjustable rate mortgage has an initial cap and a lifetime cap. These caps limit how high, or how low, the interest rate can adjust. For example, if you had a 7/1 ARM with an initial rate of 3.5%, an initial cap of 2.5%, and a lifetime cap of 5%, your rate on the eighth year (your first year outside of the fixed period) could adjust to 6% and then as high as 8.5% the following year. But the rate could not go any higher than this regardless of the market, due to your lifetime cap.
On a $250,000 mortgage, that means your initial monthly payment is $1,122.61 with a maximum monthly payment of $1,922.28 after the fixed-rate period, taxes, PMI, and homeowners insurance notwithstanding.
Keep in mind - the interest rate could also stay the same or even decrease. However, the latter does not happen often.
Let’s look at an example of a 7/1 ARM to get a better understanding of how ARMs work.
In this scenario, let’s say a home buyer wants to move ahead with a 7/1 ARM with the following numbers:
Home price: $300,000
Down payment: $50,000
Loan amount: $250,000
Initial interest rate: 3.5%
Caps: 5/2/5 (Initial cap, periodic cap, lifetime cap)
In this example, the current interest rate on a 30-year fixed conventional mortgage is 4.125%. With an ARM, they will save $131 every month with a $1,180 monthly payment - a $1,572 savings over the course of one year.
However, eventually, an ARM can lose its benefits. The rate will very likely increase. In fact, it could go from 3.5% to 8.5% - making the monthly payment as high as $2,125. Now, it is possible that rates and their monthly payments could decrease after seven years, but that’s not likely. Either way, the smart thing to do is hope for the best and prepare for the worst. Take a look at the infographic below to get an idea of the various ways an ARM could work after seven years.
Please note: The rates above do not reflect actual rates in fees and are only for example purposes. Use our real-time mortgage calculator on our home page to compare live rates.
How does an ARM compare to a fixed rate mortgage?
Plain and simple - if you plan on living in your home for a while, you should forget about going with an ARM.
Although a fixed rate mortgage may sometimes not have as low of a rate as an ARM’s initial rate, you won’t have to worry about mortgage rates skyrocketing. You’re locked-into your rate for the lifetime of your loan. And, if you notice mortgage rates are lowering, you could refinance your mortgage down the road.
However, this doesn’t take current rates into account. Below is a side-by-side comparison of a 7/1 ARM vs a 30-year Conventional mortgage over 8-years. For this example, we took live rates in mid-February 2019 for a $350,000 condo with a $50,000 down payment and average credit (660-679) in Chicago.
The 30-year Fixed Conventional mortgage has an interest rate of 5.375%. That’s a monthly interest and principal payment of $1,680. The 7/1 ARM has an initial fixed interest rate of 5.125%. That’s a monthly interest and principal payment of $1,633. In year 8, we are going to assume the rate makes a 5% jump to 10.125% for the ARM.
By taking current rates into account, you’ll see the monthly savings is $47 monthly or $564 annually. By year 8, the payment increases by $1,027 per month, and you’d want to either have sold your home or refinanced or you’ll start losing money. If not, your savings will quickly cease to exist.
Ask yourself three questions to know if an ARM is right for you.
Although fewer people tend to move forward with ARMs, they are right for certain home buyers. Before you decide, ask yourself these three questions:
1. Will you own the property for more than 7 years?
If this is just a starter home or you plan on moving in a few years, an ARM could be to your advantage if you can lock in a low enough rate for the initial fixed period.
2. Can you put the savings to better use?
The payment savings is the only reason to risk using an adjustable rate mortgage. If you want to use the early savings to pay off student loans or invest, this could be an option for you.
3. Do you think you'll be making enough money after 7 years to handle a monthly payment increase?
Even if you don’t plan on still living in the home after the fixed rate period, you’ll want to make sure you can handle the higher payments later on - assuming rates go up. If you are confident in your career path, this could make an ARM more reasonable. To find out how high your payment could go, add your initial rate (the rate you started with) to the lifetime adjustment cap (usually 5%). Then calculate your new monthly payment by using your initial loan amount, the new rate, and a 30-year term. Lastly, compare your new payment to what you pay now. Can you afford the increase?
Weigh the benefits of an ARM against the risk. Yes, you can save a lot of money with an ARM, and that can come in handy, especially if you’re a first-time home buyer. But be smart by preparing for the worst-case scenario. First, find out when the ARM will adjust, and how high the monthly payment could go. Then decide if you can handle the future payment. If you can’t and if there’s a good chance you’ll own the house after the rate changes, then forget about the ARM and go with a fixed rate mortgage.
If you want to know more, feel free to talk with one of our Loan Officers in the chat at the bottom right hand of your screen. In addition, you can compare live rates and fees with our free mortgage calculator on our home page at any time.