The cost of repaying an adjustable rate mortgage (ARM) changes over the life of the loan. As a potential home buyer you may favorably view acquiring this type of loan when interest rates are low. If you have ARM financing, your initial payment terms tend to be very good. However, your lending institution intends to make a profit before the principle (money borrowed) is repaid. That profit comes from charging interest on the principle. With an ARM your lender anticipates increasing the interest earnings over the life of the loan.
The interest rate isn’t arbitrary.
It’s tied to an index. An index is an interest rate related to the cost of doing business at high financial levels—like the Prime Rate (which is the interest rate banks charge other banks when they lend them money). However, for an ARM the Cost of Savings Index or the 1 Year Treasury Index are among the indexes more likely to be considered.
Index rates fluctuate, so they are usually quoted at a periodic average. The index used can be a 2, a 3, a 6.5—any percentage; it is determined by the process of money making money.
Your lender will add a margin to the index used. (Margin means additional interest points. There are 100 points per one percent.) Basically, the margin insures the lender of making some profit, so your credit worthiness is influential in determining it. The more risk the lender perceives in recouping the loan principle, the higher the margin will be.
Say the index your lender is using when you apply for an adjustable rate mortgage is at 3.75 and you are assigned a margin of 2 percent: This means the initial interest rate on your loan would be 5.75 percent.
I’ve mentioned an initial period or initial interest rate a couple of times. That’s because the interest rate on this type of mortgage is set up for periodic change. That variability occurs in the index rate. The margin, however, is constant for the duration of the loan.
The initial rate period is a significant issue. Depending on your loan agreement, it can last one month or up to several years. Your interest rate is fixed for this period and (often) is the lowest it will ever be. Sometimes a lender will even give you a discounted rate for this period. But, watch out! A ridiculously low initial rate might be followed by a really large increase built into the first adjustment; it’s also possible for your lender to recoup funds through high closing costs.
After the initial payment period the interest will be adjusted at predetermined intervals to reflect (then) current rate of the index to which it is tied. (An exception to this could be the first adjustment. The rate for that one is, sometimes, determined as a separate item in the loan agreement.) Subsequent adjustments will be made on a regular schedule—monthly, quarterly, semi-yearly, yearly, or every x-number of years— according to your loan agreement.
Since it is impossible to predict what an index will do over a number of years, your adjustments may result in increased or decreased interest rates. Adjustable rate mortgages are typically written for 15 or 30 years. Within those blocks of time there could be several economic booms or busts—trends that influence index rates. Indexes could vary significantly from period to period. For protection against extreme interest rate increases, insist on rate caps (periodic and overall) in your contract.
Some indexes do not allow for rate caps. You risk exorbitant interest increases if your loan is tied to one of these.
You can be sure your lender will want to include a floor. The floor is the lowest rate to which your interest will be allowed to fall. (This is, really, another type of cap—one that favors the lender.)
Another protective measure on your part would be to include a conversion clause. This clause allows you to change your adjustable rate mortgage into a fixed rate mortgage. Its terms can be negotiated.
The unpredictability of indexes and therefore of your interest rate is the great risk in taking this type of loan. The great advantage of an adjustable rate mortgage is its low initial interest rate. As you begin to repay the loan, your interest payments will be much lower than any associated with a fully fixed rate.
This benefit can often be utilized by taking a long-term loan. (If your financial profile is good, that can help in securing a lower margin.) Negotiate the longest initial rate period you can. Then, pay off the loan very early. This requires you to plan ahead and arrange the financial resources to accomplish your purpose. (Of course, lenders are familiar with this strategy and may try to incorporate a penalty fee for early payoff. —It’s up to you to calculate and defend your advantage in any contract.)
Remember: When buying a house, you can shop for a loan—the same way you would shop for any other commodity. Do some product research. Then, check out several lenders, and compare available terms before applying for an adjustable rate mortgage.
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