Adjustable Rate Mortgages

Adjustable rate mortgages, commonly known as ARMs, are the most popular type of mortgages next to conventional fixed rate mortgages. How do ARMs work? Let's look at the basic premise behind all ARMs, as well as the differentiation that occurs among them.

As their name implies, ARMs are mortgages that have interest rates that change, based on an index. These indexes vary, but the most common are short-term Treasury bill rates, or the yield on one-, three- or five-year Treasury securities. Less commonly used indexes are the Federal Home Loan Bank Board's Cost of Funds rate and the national average mortgage rate, which is the loan rate average over a certain period of time.

Using the Treasury bill rate index as an example, the interest rate on your mortgage is adjusted, meaning it is lowered or raised, depending on the yield for the Treasury bill that your interest rate is indexed to, and then by adding a margin amount. Think of the margin as the lender's profit, because that's what it is. How do you know the amount of the margin? Basically, the margin, which is often a percentage amount, depends on the lender and is the same throughout the term of the loan.

Tip Since the margin amount remains the same rather than changing the way the index rate does, it's important to find out what margin percentage your lender charges so you can figure out the amount you will actually be paying. Don't make the mistake of focusing solely on the rate and ignoring the margin amount when deciding on a lender and a mortgage.

How often does this interest rate adjustment take place? That all depends on the type of ARM you have. There are many different types of ARMs available. Some adjustable rate mortgages have interest rates that adjust once a year, usually each year on the date you took out your mortgage. Some ARMs have a fixed interest rate for two, three or five years. After that, the rate is adjusted annually, every couple of years, or whatever the mortgage specifies. The interest rate for some ARMs is adjusted once after the initial period and then the rate remains the same for the remainder of the mortgage term, which also varies. This is often referred to as a convertible ARM because you are, in effect, converting an ARM to a fixed rate mortgage. The ability to convert an adjustable rate mortgage to a fixed rate one is sometimes offered as an option to ARM holders. If your ARM is a convertible mortgage, you may have to pay a fee to exercise this option.

Because their interest rates are adjustable, does this mean the interest rate could skyrocket on you if you choose to use an ARM to finance your home purchase? The answer is a qualified "yes," and it depends on your definition of skyrocket. Most ARMs have limits on how much the interest can rise annually and over the term of the mortgage. These limits usually range anywhere from 2 percent annually to 6 percent over the life of the loan.

When to choose an ARM. At this point you may be wondering why you would want to take a chance with an ARM if you can qualify for a nice, safe fixed rate mortgage? If you do qualify for a fixed rate mortgage and the interest rates are low, it's usually best to lock in a great rate for a long term. However, if you don't qualify for a fixed rate mortgage, it may be easier for you to get an adjustable rate mortgage instead. And if interest rates are on the higher side, it may not make sense to lock in for the long haul. Also, ARMs usually start off with a lower interest rate than you can get for fixed rate mortgages. This can save you a lot of money for the first few years of a mortgage, particularly when interest rates for mortgages are high.

Even if mortgage interest rates are low, your individual situation might make an ARM the better choice for you. For example, if you don't plan on staying in your house for more than a few years, and you finance your purchase through an ARM, you'll pay less interest for the first few years than with a fixed rate mortgage, even if the interest rates are low. Another situation where an ARM might be the right mortgage to use is if you are just starting out in your career and you know with some degree of certainty that your income will be going up. With an adjustable rate mortgage, your monthly payments will start out lower, at least for the first few years, and if the monthly payments go up, so will your earnings.

Example Newlyweds Blake and Ryan decide to purchase a starter home that costs $100,000. By pooling their individual savings and monetary wedding gifts, they manage to raise the $20,000 they need for a 20 percent down payment. That means that the mortgage loan amount they need to borrow is $80,000. Ryan is employed as a high school teacher, and Blake is currently attending graduate school to earn her MBA. While the couple's monthly income is low for now, they expect it to go up substantially in a few years when Blake embarks on her promising career as an up-and-coming company executive. Ryan and Blake are eligible for a 30-year fixed-rate mortgage, with an interest rate of 6 percent. This would mean a monthly mortgage payment of approximately $480. If the couple uses an adjustable rate mortgage to finance the purchase of their home, their interest rate is guaranteed to stay at 4 percent for the first five years of the mortgage term. That means that their monthly mortgage payment for the first five years will be around $382. Ryan and Blake decide that the ARM is the best fit for them. They will be better able to afford the ARM monthly payments and will invest the almost $100 a month they save with an ARM mortgage. In five years, they plan to sell their first home and purchase a bigger one once Blake is working full-time in her chosen career and they start a family.

Prepayment penalties. As is equally true for fixed rate mortgages, you must make sure that your ARM does not have a prepayment penalty clause. A prepayment penalty kicks in if you pay off your mortgage before the end of its term. When you take out your mortgage you may think that this doesn't apply to you because you'll never be able to pay your mortgage off ahead of schedule--you'll have enough trouble paying it on schedule! Please heed our advice because if an event occurs that puts you in the financial position to prepay your mortgage, we want to spare you the expense of having to pay a penalty for doing so. Note that some states prohibit prepayment penalties.

Calculating your monthly payment. If you think that an adjustable rate mortgage might be the best choice for financing your home purchase, use the calculator below to figure out what your monthly mortgage payments add up to. Remember to make sure that you understand how your interest rate will be computed when it changes from the initial rate you pay.

Financial Calculators Use this Fixed Mortgage Loan Calculator to help you generate an amortization schedule for your current mortgage. Quickly see how much interest you will pay, and your principal balances. You can even determine the impact of any principal prepayments! Press the "View Report" button for a full yearly or monthly amortization schedule. Adjustable rate mortgages can provide attractive interest rates, but your payment is not fixed. Use this Adjustable Rate Mortgage Calculator to help you determine what your adjustable mortgage payments may be.