Many Ventura County residents may know what an Adjustable Rate Mortgage (ARM) is. If for no other reason, these types of loans generated a lot of headlines during the housing crash and great recession. While these loans can potentially carry some amount of risk, they do not have to necessarily be a bad thing and can actually work in your advantage if used correctly and you understand what you are getting into. Although I have yet to see any data backing this up, there has been a lot of talk recently saying that there are a large number of ARMs out there that are either resetting or set to reset shortly. For those homeowners who either have an ARM or may be interested in pursuing one in the future, this post will give some information on how exactly they work and what that means to you.
What is an Adjustable Rate Mortgage?
When most homeowners purchase a home and obtain a loan from a bank, they usually end up getting a fixed rate mortgage. This means that the interest rate you are paying on the loan is fixed for the entire life of the loan (assuming you do not refinance). Since the interest rate is fixed, this also means that your monthly mortgage payment will be the same amount for the life of the loan. The most common terms for fixed rate mortgages are 15-year and 30-year loans. Unlike a fixed rate mortgage, ARMs have interest rates that can fluctuate up or down on a regular basis based off of the market conditions and the terms of your loan. They usually have an introductory period in which the interest rate remains fixed and then transition to a period where the interest rate fluctuates for the remainder of the loan. The most common ARMs adjust on a yearly basis, so that means that the interest rate (and the corresponding monthly payment) you are paying will most likely change every year. For example, you may have heard of a 5/1 ARM or a 7/1 ARM. In these examples, the number before the “/” represents the number of years that the interest rate remains fixed and the second number represents how often the interest rate will adjust. So a 7/1 ARM means that your interest rate will remain fixed for the first 7 years and then it will adjust on a yearly basis for the remainder of the life of the loan.
Types of ARMS
Fully Amortizing ARM: The monthly payments on this type of loan will be calculated such that you will have paid off the entire balance at the end of the life of the loan. So if you have a 30 year loan, your monthly payments will be the exact amount that will have your loan paid off at the end of the 30th year. In the case of an ARM, every time your interest rate resets, your monthly payment will be adjusted to keep you on track for paying off the loan amount on the proper timeline. Keep in mind that during the fixed rate period, you are paying down the principle, unlike the interest only ARM.
Interest Only ARM: With an interest only ARM, the initial fixed rate period requires that you only pay the specified amount of interest on the loan. Since you are not paying down the principal during this period, this means that your monthly payment will only consist of the interest, and hence could be significantly lower than if you had a fully amortizing ARM. However, once the introductory period is over, your monthly payment is recalculated such that you now have to pay interest AND principal for the remaining life of the loan. So if you had a 7/1 interest only ARM and were only paying the interest for those first 7 years, you would then only have 23 years to pay off an amount that you would have normally had 30 years to pay off. As you can imagine, this could lead to a very high monthly payment. If you add in the fact that your interest rate will likely increase as well, this could have the potential to spell disaster to homeowners who did not plan accordingly.
Payment-Option ARM: This is a type of loan that gives you different options to choose from when paying your loan. The most dangerous of these options is the one where your payment does not even cover the amount of interest you are being charged. In this case, any of the interest that you do not pay is added to the principal balance of the loan, meaning that the amount you owe is actually getting larger. Obviously, when the introductory payment ends, the owner of this loan will be stuck with a huge monthly payment to cover a mortgage that is larger than when they first started making payments. Although I am not sure how many institutions still offer an option to pay less than the interest, if any, you should still be aware of what this is in case some unscrupulous person or company tries to entice you into signing up for this without explaining the ramifications.
How will your rate adjust after introductory period?
Once your introductory period ends, the interest rate of your ARM will adjust up or down based off of another interest rate, known as the index. There are several indexes that your ARM can be tied to, including the 11th District Cost of Funds Index (COFI), the Cost of Savings Index (COSI), or the London Interbank Offered Rate (LIBOR). The paperwork for your loan should identify which index your loan is tied to. Along with the index rate, the lender will add an agreed-upon amount of percentage points, also known as a margin. Normally, the better your credit history, the better rate you will get on your margin. This margin is fixed for the life of the ARM and will not change regularly whereas the index will adjust on the periodic agreement of your loan. So your new ARM rate will be the interest rate of your index plus the margin. So for example, let’s say your ARM adjusts on a yearly basis and you have a margin of 4 points. If the index for the year following your fixed rate period is 2.5%, your new interest rate would then be 2.5 + 4 = 6.5%. If the index the following year increases to 3%, your interest rate for that year would be 3 + 4 = 7%.
What does this mean for Ventura County residents?
Hopefully, this post has shown you that although ARMs are not overly complicated, there is a little more that goes into understanding them than fixed-rate mortgages. If used correctly, ARMs can have the advantage of getting you into a home at a lower rate than you would get from a fixed-rate mortgage. However, if you are not prepared for the rate adjusting after the introductory period, you could be putting yourself into financial jeopardy, especially if market conditions take a turn for the worse. For most people, I would recommend sticking with a fixed-rate mortgage. Although your interest rate will be a little bit higher than the introductory rate of an ARM, you will know what your monthly payments will be for the entire life of your loan. Since no one can predict what market conditions will be 5 or 7 years down the line, it is probably best to be safe knowing how much your mortgage will be than risk the chance of not being able to refinance out of the ARM or afford the payment when the rate resets.