Should you buy Adjustable Rate Mortgages (ARM)?

Before the economic crisis that started in 2008, ARMs were an important part of the mortgage industry. In the United States, they constituted 49.7% of all mortgage deals. However, by 2009, they were only 2.8% of all mortgage deals. As the economy has made a recovery from the effects of the financial crisis, there has been a corresponding increase in the interest in ARM. Last year, 14% of mortgage deals were ARM.

Therefore, many people are seeking to understand what ARMS are, how they differ from fixed-rate mortgages, and, most importantly, if they are worth considering.

What Are Adjustable Rate Mortgages?

ARM are mortgages whereby the interest rate on a loan is variable or adjustable.  There are different types of ARM, but the most common is the hybrid ARM. The hybrid ARM allows you to pay a lower rate of interest on your mortgages for the first three, five, and up to ten years of the life of the mortgage. After the initial period, the rate of interest on the mortgages adjusts to match the realities of the interest rate environment.

The new interest rate is based on a very simple formula- Index plus Margin. The index can be the maturity yield on one-year treasury bills, the cost of funds index, or the London Interbank Offered Rate (LIBOR). The margin is an agreed-upon percentage that is added to the index rate to arrive at the interest rate for that period. Therefore, if the LIBOR is 2% in a particular period and the margin rate is 2.75%, your interest rate will adjust to 4.75%.

Adjustable-rate mortgages are the opposite of fixed-rate mortgages. With fixed-rate mortgages, you lock your interest rate on the mortgage. You pay the same rate of interest in the first year and the thirtieth year. You can only get out of a particular deal through refinancing.

The ARM will include details on how often the rate adjusts. Some ARMs adjust every six months. Some ARMS adjust every year, and others adjust every month. What this means is that every six months (or one-month or one year), the lender recalculates the interest rate on the mortgage using the above-stated formula (index plus margin).

Different lenders give out different ARM deals. The deal is put in the format a/b, where “a” is generally the fixed period (the number of years where you pay a fixed rate), and “b” is the frequency of adjustment. The most common deal is the 5/1, where the mortgage is fixed for five years and adjusts every year. A 5/5 deal adjusts every five years while a 5/6 deal adjusts every six months. Some lenders use another format where a represent the fixed part while b represents the variable/adjustable period rather than frequency. In that case, a 2/28 deal means it is fixed for two years and adjustable for twenty-eight years. In that scenario, the lender will disclose the frequency of the adjustment somewhere else.

However, there are other types of ARM. There is the interest-only adjustable-rate mortgage where your monthly payment is assigned to interest payment alone for a specified period (between three to ten years). After the specified period, the lender assigns your monthly payment to both interest and principal amount. The interest rate adjusts during both periods. There is also the payment option adjustable-rate mortgage that allows you to choose between three different options every month. You can choose to assign the payment to payment and interest, to interest alone, or even pay a limited payment that is less than the interest payment while they add the unpaid interest and principal to the loan balance.

Rate Caps and Adjustable Rate Mortgages

The most popular type of ARM is the hybrid ARM, which will be our focus in this article.

Most ARMs have what is called a rate cap. The rate cap places a ceiling on how much the interest rate you pay on the mortgage can increase during the adjustable period. There are two types of rate caps.

• Adjustable cap: The adjustable cap fixes a maximum rate of increase allowed at each adjustment. For example, if you apply for a 5/1 mortgage that adjusts every year after the fixed years (five years in this case), it means the rate for this year cannot be higher than that of last year beyond a certain percentage value. If last year’s rate is 4% and the rate cap is 2%, it means this year’s rate cannot exceed 6% irrespective of the change in the index.

In some cases, some lenders may allow a sort of carryover. In such cases, if the actual rate (index plus margin) is 6% and the last year’s rate is 3%, but there is a rate cap of 2%, the 1% that is cut off as a result of the cap may be carried over to another adjustment period where the increase is rate is less than the rate cap (given the carryover will not exceed the rate cap.)

• Lifetime Cap: The lifetime cap sets a limit on the highest rate you can have over the mortgage lifetime. For example, if a lifetime cap is 6%, it means the rate you pay on that mortgage can never be higher than 6%, no matter what happens to the index.

Advantages of Adjustable Rate Mortgages

Why is it that people even consider ARM? If the rates you will pay in the future is susceptible to change and increase over time, why consider an adjustable-rate mortgage? Below are some advantages:

• Lower interest rates at the beginning make sense for those who do not plan to stay in the house for long. If you do not have a plan to stay in a house for more than five or seven years, you can get an adjustable-rate mortgage and save some money during the time you are paying for the property. The hybrid ARM allows you to pay a rate that is lower than the fixed-rate mortgage for the first three, five, seven, or ten years of the mortgage lifetime (depending on the lender). If you do not plan to stay beyond the period where the interest is fixed, then taking an ARM will save you some cost on your monthly payment.
• You can take advantage of lower rates of interest without refinancing. When the index rate drops because of a fall in interest rate, the rate you pay on the mortgage also drops. For those locked in a fixed-rate mortgage, the only way to get the advantage of falling interest rates is to refinance their mortgage. Refinancing comes with extra closing costs and fees. However, with ARM, you can benefit from lower rates without extra cost.
• You can invest the amount you save on monthly payments for the fixed portion of the mortgage in other profitable opportunities. As said before, the interest rate on ARM for the fixed portion is lower than the lifetime rate of fixed mortgages. You can invest those savings in some high yield investments.
• More valuable offers: With an ARM, the lenders take on lesser risk compared to fixed-rate mortgages. As a result, the lenders are more open to give you offers that are more valuable (in terms of the cost of the property). You can get offers from ARM lenders that you will not get from fixed-rate mortgage lenders.

Disadvantages of Adjustable Rate Mortgages

Nevertheless, there are certain disadvantages to ARM. Some of them include:

• Complexity: ARMs are typically complicated. It is hard to understand for many people. There might be some terms and conditions you miss that affect you in the long run. Understanding everything that revolves around ARM is difficult.
• Increasing interest rates: Those with fixed-rate mortgages have protection against an increase in the interest rate. However, when interest rates are increasing, the ARM holder has significant exposure. The only good news is the rate caps that maximizes the influence of increases in rate. Yet, it is still a significant exposure, and rate caps can be confusing sometimes.
• Makes financial planning more difficult: The mortgage is one of the most significant items on the average person’s monthly budget. With an ARM, it is more difficult for you to plan or budget since you cannot know what you are paying at a particular time after the fixed period. Such uncertainty is not good for the budget or financial life. Thought the rate caps reduce the uncertainty, the one that remains is still significant.
• It can become unnecessary when the rate during the fixed period is very close to the fixed-rate mortgage interest rate. For example, if you can get a fixed-rate mortgage with 3.75% and the ARM is 3.8% for the first five years, it becomes unnecessary taking up the ARM.

Should you buy Adjustable Rate Mortgages?

There are certain factors to consider before making this decision.

The interest rate environment

If interest rates are relatively high, the expectation is that they will fall going forward. In that case, ARM makes sense. It allows you to enjoy lower rates for the fixed period compared to the high-interest rate. Yet, you get to enjoy lower rates even in the adjustable period since the expectation is falling interest rates. On the other hand, if interest rates are relatively low and the expectation is that they will rise, it makes little to no sense to take up an adjustable-rate mortgage, ceteris paribus.

How long you plan to stay in the house

If you plan to stay in the house for a long period, a fixed-rate mortgage is a better option. ARM makes sense when you plan to stay in that property for a short time (that is within the fixed period of the ARM)

The interest rate on fixed-rate mortgages

If the interest rate on fixed-rate mortgages is almost equivalent to the best ARM deal, then it makes little sense to go for ARM. ARM will make sense when there is, to some extent, a significant difference (0.5% is significant to some extent) between the fixed-rate mortgage rate and the rate of the fixed period of the ARM. (Ceteris paribus)

Risk appetite

If you are risk-averse and you can’t deal with uncertainty, don’t go for ARM. If your income is unstable and you have little savings, don’t take adjustable-rate mortgages.

Earnings Expectation

If you expect an increase in income that will match the adjustable period of the mortgage, you can take the adjustable-rate mortgage to enjoy the cost savings of the fixed period. This is also important if you have good investment opportunities that bring good returns for the cost savings.

Conclusion

Adjustable-rate mortgages can be a world of immense complexity. However, they can also offer some good benefits that might be relevant to some people. The general personal finance wisdom is to be skeptical with ARM until you have very good reasons to take one. If (when) you decide to take one, be sure you understand the nitty-gritty and there are no hidden terms and conditions that can hurt you.