Adjustable rate mortgages:
The ups and downs of ARM

by Shawn Carvin, Senior Mortgage Banker

Adjustable rate mortgages (ARM) have a somewhat dubious reputation. We’ve all heard of people who took on an ARM because of the customer- friendly low initial interest rate and payments, but who eventually faced a financial crisis because they weren’t prepared for the higher payments once the rate changed. So should you automatically dismiss the possibility of an ARM when researching mortgage options? Let’s take a look.

How do adjustable rate mortgages work?

As its name suggests, an ARM has an adjustable interest rate. That means the rate will change periodically depending on the terms of the loan. Usually, the initial rate is lower than the going rate for a 30-year fixed mortgage, resulting in lower monthly payments. Most ARMs have an initial interest rate based on an index rate plus an added margin. The index rate reflects the average wholesale cost of money for banks and financial institutions. The margin is essentially the lender’s profit. Mortgage lenders can afford to offer a relatively low initial rate on an ARM because they can increase the rate over the life of the loan and continue to make about the same amount of profit on the loan.

How high can the interest rate of an ARM go?

There are limits — called caps – which limit the maximum amount of each adjustment, and how high the interest rate can increase in total over the life of the loan. For example, if the initial rate is 4.75% and there are caps of 2% per annual adjustment and 5% over the life of the loan, then the rate can only go up 2% each year and the rate can never exceed 9.75% during the lifetime of the loan.

Can ARM interest rates go down over time?

The interest rate on an ARM can also adjust downward. If the index rate decreases, then so will your interest rate, but there’s usually a lower limit to the rate that it won’t drop below. The terms of the loan will usually allow the rate to be adjusted annually, but on some mortgages adjustments are scheduled more or less frequently. There are also “hybrid” ARMs that will fix the initial rate for three, five, or even seven years, at which point the rate will then begin to change periodically.

Are adjustable rate mortgages a good deal for borrowers?

The answer is a qualified “maybe.” An ARM can be an effective financial tool for savvy borrowers with certain goals. One of the most common uses for an ARM is for borrowers who plan to buy and sell a home within a relatively short period of time. An ARM can permit such buyers to take advantage of below-market interest rates and sell the home before an adjustment increases the rate.

Another scenario where an ARM makes sense is when interest rates are relatively high and the borrower feels confident prevailing rates will drop over time. In this situation, an ARM will give the borrower access to lower rates without the need to refinance the home, unlike when purchasing with a fixed-rate mortgage. But if rates do drop significantly over time, refinancing with a fixed-rate loan to lock in the lower rate is usually the smart move.

What if the ARM rate goes up and you have difficulty paying your mortgage?

It’s important to remember that while you may not know exactly how much your payments are going to go up at the next adjustment, you will know when they will go up, so an adjustment should never catch you by surprise.

The best advice is to make sure you can still afford the payments in a worst-case scenario under the terms of your adjustable rate mortgage. Chances are, you will fare better than the maximum increase limits of your loan and pocket considerable savings. But if you aren’t confident that you’ll have the financial capability to cope with the worst-case scenario, you should probably reevaluate your plans and proceed on a more conservative path.