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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: 

• If your time horizon to stay in that house is only for a few years, getting a 3, 5, 7 or 10 year fixed may save you hundreds of dollars per month.  f you are confident that you will remain in the house for a relatively short period i.e. less than the loan's fixed-rate period,  then an ARM may make sense. You can sell the house or refinance the loan before the rate is reset.
• In general rates for ARMs are about 1% lower than 30 Year Fixed. That translates to higher purchasing power and to remain within allowable debt ratios. 
• Lower rates also translates to lower monthly mortgage payments. 
• If you anticipate a promotion with salary increases - ARM is a good program to get you the dream house that you may not be able to qualify with conventional 30 year fixed. Borrowers who can realistically expect a significant increase in salary before the rate reset such as medical residents or law students may benefit. However, ARMs may be too risky for hourly earners looking at an Adjustable-Rate loan as the only option to qualify for a home purchase and potentially unable to make the higher payments down the road when it resets.  
• ARM is a good option if you have the financial discipline and financial ability (such as anticipating salary promotion above) to withstand major interest rate fluctuations and potentially a significantly higher payment as well. 
• ARM is a good option if current trend of high and climbing interest rates is unsustainable and that rates will drop and allow you to refinance in the future. 
• At the end of the day - it boils down to your comfort risk and risk tolerance level.

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: 

1. What the Index is. This could be SOFR, COFI, Libor, CMT, CODI, and Prime Rate. Then check out from this website to ascertain what your current Index value is.
2. As of November 30, 2020, the Federal Reserve announced that LIBOR will be phased out by end of 2021 and will be replaced by SOFR. All contracts using LIBOR should wrap up by June 30, 2023.  
3. What the margin is. This is usually fixed for the duration of the loan and could vary from .75% to 7%.  
4. What the adjustment cap is.  
5. What the lifetime maximum rate adjustment is.   

Example 1.

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). 

Example 2.

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).

Example 3.

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.