Is an ARM Right For You?

Let’s start by taking a look at 7 key elements of an adjustable rate mortgage:
1) 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 lender’s “margin” to that, and you’ve got the rate.

Add costs to that, and you’ve 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.
2) 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.
3) 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%.

What’s 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, doesn’t necessarily mean it’s 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.
4) 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.
5) 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, let’s 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.
6) 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.
7) Conversion Clause:

What if 5 years go by, and the rates are still low, and now you’re fairly certain you’ll 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, that’s a question that only you can decide.

However, here a few possibilities:
1. Buying Power: - Adjustable Rate Mortgages, in the right market, can allow buyers to purchase higher valued homes with a lower, initial, monthly payment.
2. Short Term Home Ownership: - The average home owner lives in one residence 7 to 8 years (not 30 years).

Do you know how long you’ll be there?

If you have confidence that you’re only there for the short term, then an ARM could save you money.
3. 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.

Let’s 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, don’t 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.

We’ve 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 LevineCopyright 2004, by LoanResources.

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About The AuthorTom 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.

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Tom Levine