ARMs have a reputation problem.
During the housing bubble, Adjustable Rate Mortgages (ARMs) caused financial distress for many homeowners. This was partially due to toxic loans, as well as a lack of comprehensive education about the pros and cons of this type of home financing.
According to Ellie Mae, ARMs accounted for 38.5% of all mortgage applications in 2005. One decade later, they had fallen out of favor, with only 5.3% of borrowers choosing in ARM in September 2005. As of mid-July 2017, the number had inched up with 6.8% of applicants choosing an ARM.
Why the change of heart?
There are numerous reasons why borrowers are once again looking at Adjustable Rate Mortgages. For one thing, today’s consumers are more educated about their financing options.
Another impetus is the fact that interest rates are starting to creep up again and this is one way to secure a mortgage with a lower initial rate. In addition, financial institutions learned many lessons after the housing meltdown that began around 2008.
What exactly is an ARM?
An Adjustable Rate Mortgage starts out with a relatively-low interest rate that lasts for a pre-determined amount of time—typically 5, 7 or 10 years. For example, a 5/1 ARM carries a fixed rate for five years and then the rate is adjusted annually for the life of the loan. After the initial fixed-rate term, your rate will be adjusted based on the index plus margin.
The Index is a benchmark rate based upon general market conditions.
This amount is established by a third party, but your lender will choose which index it uses. The most common one is the one-year LIBOR (London Inter-Bank Offer Rate) and can be found on websites including the Wall Street Journal
. LIBOR is the rate most international banks are charging each other on large loans.
The Margin is established by the lender at the time you apply for your mortgage.
This amount typically doesn’t change after closing.
Usually, your ARM will have a cap on rate increases—for the life of the loan and sometimes at each adjustment—so you’ll know ahead of time what the maximum rate would be. It’s important to remember that your rate could
go up, not that it will definitely
Is an ARM right for me?
Every borrower’s goals, finances and stage of life differ, so there’s no single “right” answer. It’s important to honestly discuss your anticipated housing needs and financial situation with your lender, so he or she can help you consider all of your options. Here are a few examples of when an ARM could be appropriate:
- If you’re a first-time homebuyer who needs a lower initial interest rate in order to afford a larger home, this might make sense for you. This concept is popular with people whose careers typically experience rapid increases in income (physicians, attorneys, etc.).
- If you’re purchasing property for a short-term investment, an ARM may be a good option.
- If you’re planning to move or upgrade your home within a short amount of time (around 5-7 years), you can enjoy savings early on and sell your home before (or around the time) the rate adjusts.
Like anything in life, a little bit of education can go a long way toward making a wise decision. If you’re considering a home purchase, it’s never too early to begin exploring your mortgage options.
- By Coral Herman,
Aug 25, 2017