I’ve worked in the financial industry for 20 years, and in residential lending for half of that time. I don’t work in mortgages anymore, but I know one thing, mortgage products and regulations change constantly. Be an educated consumer. Understand what you’re “buying” in a mortgage. Adjustable rates aren’t as scary as you think.
How an adjustable rate works
Adjustable rate mortgages (ARM) offer a wide variety of terms: 1/1, 3/1, 5/5, etc. The first number represents the # of years before your first rate review, the second indicates subsequent review periods.
If you’re a first time homebuyer, or looking to refinance, and you know the house you’re in or are considering buying, is one you won’t stay in for long, an ARM may be for you. Why? Because you may sell before your rate changes. You’ll enjoy a rate lower than the current 30 year fixed mortgage rate, and be gone before your mortgage payment adjusts significantly. But keep in mind, life isn’t a guarantee. Markets change, jobs change and life changes. Understand your worst-case scenario. Understanding how an adjustable rate mortgage works will give you a greater feel for the risk you’re taking.
ARMs have “caps”. These reflect the maximum change allowed at adjustment time. Frequently shown as three numbers: 2/2/5 (for example), this represents a maximum change of 2% (up or down) at the end of the initial period, then as much as 2% on each subsequent adjustment, and never more than 5% over the life of your loan. A 3/1 ARM with similar caps would be subject to the following possible adjustments
- End of year 3 – Up to a 2% adjustment
- After each year following – Up to a 2% adjustment
- Total maximum adjustment over lifetime – 5%. Meaning your rate is never higher than 5% above the rate you closed at.
If you prefer more stability, look for an ARM with a longer adjustment period, like a 5/5 ARM. These result in an initial adjustment after the first 5 years, then adjust every 5 years, rather than yearly as with the 5/1 ARM.
Index and Margin
Mortgage rates are calculated by adding a margin to an index. Indexes vary and are usually published in the Wall Street Journal. Bankrate provides a great explanation of how these work. The margin (which remains constant) is added to the index to come up with your rate. You may get a discounted start rate. But regardless of the discount, the cap is the cap. That way you know “worst-case”.
Having a Plan
If you think an ARM is for you, do your research. Know the margins and index. Know what your maximum payment could be. Understand worst-case scenario, and give some thought to how you’d handle that higher payment if in fact you don’t end up moving or refinancing.
For years people have felt that a 30 year fixed rate mortgage was the best and safest way to go. But in reality, if you understand your options, applying for a variable rate mortgage may allow you to enjoy a lower monthly payment for a number of years. It’s worthy of consideration.
Consumer Finance Government Site