June 25th, 2022 12:41 PM by Salim (Sam) Kader MLO# 130505
In a rising interest rates environment - Adjustable-Rate Mortgage (ARM)s are more attractive compare to Fixed-Rate Mortgage due to its lower initial rates. The combination of higher home prices and costlier mortgage rates are again making Adjustable-Rate Mortgages attractive to homebuyers because the starting rate is generally lower than the Fixed-Rate home loans.
Adjustable-Rate Mortgages known as ARMs have rates that are initially fixed for a set time span such as 3, 5, 7 or 10 Year and then it resets to a predetermined formula. ARMS haven't been popular in recent years because Fixed-Rate Mortgages remained low. ARMs also earned a bad reputation in 2008 financial crisis when underqualified borrowers lured by initially low interest rates were unable to keep payments when they rose. However, new laws passed since the financial crisis made ARMs much safer and transparent now. For example, lenders are required to ensure borrowers have a reasonable ability to repay the loan and ARMs no longer have prepayment penalties so borrowers can more easily pay -off or refinance the loan if they can't afford higher payments.
Today's ARMs are safer and are fully amortized - they typically have an initial fixed-rate period of at least 3 years and limits on how often and how much the rate can rise after that. Risky ARMs that let borrowers pay just the Interest Only (IO) option with negative amortization or choose their own monthly payment amount or PICK A PAY have been removed. Borrowers have to weigh-in risk of higher interests rate after the initial fixed period to be sure that they can afford bigger payments should they not being able to sell their house or refinance the loan during the fixed pay period. No one can forecast what rates will be in 3,5,7 or 10 years from now. However, as of the writing of this blog - rates are rising. ARMs rates are generally 1% lower than Fixed-Rate mortgage. For example, 1% difference in mortgage rates on a $500,000 loan translates to $417 savings per month ($5,000/12 = $417). Since there is no pre-payment penalty, homeowners can refinance at anytime when the right rate opportunity arrives.
In the long run, having a Fixed rate mortgage is still the best option. However, during this rising rate environment when the Fed is continually adjusting Fed Fund rates in efforts to tame inflation, ARMS may be something to consider. Think of having ARMs as short-term solution or bridge loan especially if you are first-time homeowners looking for a starter home and not forever home.
Here are some FAQs about Adjustable Mortgages:
Q.1 - What does it mean when an ARM is advertised as 3/1, 5/1, 7/1, or 10/1 ?
A. The first number refers to the fixed-rate period (3,5,7 or 10 Years). The second number is the number of times the rate change after the fixed-rate period - once a year.
Q.2 - When does an ARM make sense?
A. Here are a few scenarios when ARM makes sense:
Q.3 - Can the interest on an ARM be reset to lower rate?
A. Yes. After the initial repayment period, ARM rates are based on a benchmark market index such as SOFR (see below) - so it the index falls, the rate on the loan can too.
When the initial Fixe-Rate period is over and ARM rate resets - here are some useful ARM information that you should know:
If your current ARM is 3%, Index Rate is 5%, Margin is 3%, Adjustment Cap is 4% and Lifetime Adjustment Cap is 12%. Then the new rate is 7% (Current rate of + Adjustment Cap).
If your current ARM is 5%, Index Rate is 5%, Margin is 3%, Adjustment Cap is 4% and Lifetime Adjustment Cap is 12%. Then the new rate is 8% (Margin + Index).
If your current ARM is 6%, Index Rate is 5%, Margin is 8%, No Adjustment Cap and Lifetime Adjustment Cap is 12%. Then the new rate is 12% which is the maximum Lifetime Adjustment.
In the above examples, we are to consider the lower of the two from the following calculations:
a) Current Rate + Adjustment Cap or
b) Margin + Index.
Please read the revised 2020 CFPB CHARM booklet for further information. The Consumer Financial Protection Bureau or CFPB offers a useful guide to Adjustable-Rate Mortgages that can help you evaluate your loan. ARMs are more complex than traditional mortgages so borrowers need to take time to truly understand the terms of the loan.
Please consult me for an ARM Vs. Fixed-Rate mortgage analysis rate option for your consideration.