An “ARM” or an “Adjustable Rate Mortgage” is a mortgage that has a variable interest rate and APR.
Though some specific terms of agreement and other aspects of this mortgage product may vary, all adjustable rate mortgage products have an adjustable interest rate. Generally ARM’s have an interest rate that is attached to some industry standard indicator such as the LIBOR average or other applicable index that the mortgage interest rate adjusts with. Often the calculation of the interest rate is found by combining the value of the index and adding an additional fixed amount such as another two percentage points.
For example, one may have an ARM mortgage with a interest rate that is calculated by referencing the “ACME average mortgage rate indicator” plus 2.2 points. So if the ACME rate is 4.36% then the ARM rate will be 6.56%
The adjustments typically do not adjust with every tick of the index but rather at a fixed interval of time behind the average of the index. For instance, if the index jumped 2 points in 2009 then in 2010 the interest rate would adjust accordingly.
Why are Adjustable Rate Mortgages so Complicated?
You may be asking yourself why lenders, or anyone else, would want to go through this hassle of having to calculate and recalculate these interest rates instead of just making it simple on themselves by handing out a fixed rate mortgage.
You may have also noticed that at any given time a fixed rate mortgage has a rate that is higher then the adjustable rate mortgage. Typically a fixed rate is 30-35% higher then a adjustable rate mortgage
This is no accident. Even though the adjustable rate mortgage is more of a hassle, and more importantly, it tends to have a higher cost, compared to the fixed rate, when it comes to maintaining the loan specifics and calculating the mortgage payments. There are reasons for this. Two incentives create a savings for the lender if they are able to get you to agree to an adjustable rate mortgage.
Less risk and higher liquidity
Because the loan s interest rate shifts with the current market the lender knows that the loan will always be competitive no matter where interest rates head in the future. This is opposed to the alternative of a fixed rate mortgage that will not change.
Mortgage interest rate reset options to replace the teaser rate
Lenders and loan originators eventually discovered that a ARM lends itself to a profitable hybrid version of the standard prime mortgage loan. Lenders began to lure consumers in to loans with teaser rates which create a much lower payment. However these teaser rates as the name implies don’t last long typically for 1 to 5 years and then the mortgage rate “resets” to a much higher rate and more profitable return.
How does a Adjustable Rate Mortgage Effect You?
ARM’s have both good and bad qualities from the homeowners perspective.
This mortgage product will allow you, the borrower, to take advantage of any market drop in mortgage rates. To put it in another way any time the mortgage industry goes through a period of low or cheap mortgage rates then the borrower of an adjustable rate mortgage will see their mortgage payment trend lower.
Often borrowers will have an extra low teaser rate for a period of time that traditionally ranges from 1-5 years.
Just as rates will decrease with the market so to will they increase
The terms of an ARM in some cases have been missed understood by borrowers. These borrowers may have made the mistake of assuming a teaser rate or other extra low rate that was obtained early on in the mortgage was some sort of indicator of the interest rate over the life of the mortgage when in fact this was not the case. Homeowners with an exotic ARM often find themselves in financial hardship due to the mortgage rate reset which raises the amount of their monthly mortgage payment.
Consider Refinancing into a Fixed Rate Mortgage
If you have a adjustable rate mortgage you may want to consider refinancing into a fixed rate mortgage. The current interest rates are incredibly low historically speaking and will eventually go back up to typical levels and maybe even above historic average levels in the future sending the monthly ARM mortgage payment skyrocketing and blowing your budget