Things to Look for in an Adjustable Rate Mortgage (ARM)

Things to Look for in an Adjustable Rate Mortgage (ARM)

There are five prime components in most Adjustable Rate Mortgages (ARM) which must be understood and examined. One that, at first, appears to be the best option may, in fact, be the worst of your choices if ALL components are not reasonable. Here is a brief guide to help you become informed and enjoy some money-saving knowledge.

• Start Rate : The initial interest rate you receive at closing. While important for debt-to-income qualification and future increase reasons, it also might be the least critical of the components. This rate will be charged until the first adjustment date. If you choose a one year ARM, the start rate is important, but surely neither critical nor overly advantageous. However, if your loan is a five year ARM or a 5/1 (five years fixed, then becoming a one year ARM), the start rate can be very important and beneficial. Make sure the start rate is discounted enough from the 30-year fixed rate to warrant the future risk of increases.
• Index : The third party rate used as the basis for interest rate adjustment calculations. Ask your prospective mortgage lender to give you the past ten years' history on any index used by a loan you're considering. They have this information and will give it to you. The most popular of these are the U.S. Treasury Bill index, the LIBOR (London InterBank Offered Rate), and the 11^th District Cost of Funds (COF) rate. These have been used for many years and normally have reasonably slow changes, which is good for you. If you consider any ARM using an index different from these, be careful. Examine the past ten year history of the index and see how their rates changed. If you find a program that works for you and it's a true third party index, you should consider this loan.
• Margin : The percentage that will be added to the Index at the adjustment periods to determine the new interest rate for the coming time frame. This component is very important and will affect your rate greatly in the future. Margins vary widely, often from 2 to 4 percent. Question any margin that appears to be too high or just ignore that loan and move on. While you should have “adjustment rate” protection, a high margin could force your rate up very quickly even if your index remains reasonable.
• Adjustment Rate Cap : The maximum your interest rate can increase at any adjustment date. This is important protection for you and should not exceed 2 percent per rate adjustment if you choose a one year, a 3/1 (three years fixed), or 5/1 (five years fixed) ARM. Should you select a true three year ARM (rate adjusts only every three years), you might find an adjustment cap of 3 percent, which should still be acceptable. Any adjustment rate caps higher than these (or a loan without an adjustment cap at all) should probably not be considered. How does this work? If your current rate is 4.75 percent and your index and margin at the adjustment date add up to 7.50 percent, your maximum new rate would be 6.75 percent because of your 2 percent rate cap.
• Lifetime Rate Cap : The maximum rate than can be charged over the life of the loan, regardless what the market rate may be. For long term considerations, this may prove to be the most important component. The most common life rate cap is 6 percent. How does this cap operate? If your start rate was 4.75 percent, you can never pay more than 10.75 percent for the term of the loan, typically 30 years. While this is a critical protection, paying an interest rate of 10.75 percent would put a severe strain on almost everyone's cash flow and budget. If you look at a loan with a lifetime rate cap in excess of six per cent, either discard this choice or determine that there are one or more major rate protections included.