You wake up in a cold sweat and look around your dark bedroom. Your phone says it’s 2:07 a.m. Why are you even awake? You rack your brain trying to remember what bad dream your subconscious troubled you with. Then you remember. You have an Adjustable Rate Mortgage (ARM), and you have a vague nagging feeling it is going to start adjusting sometime in the near future. When is D-Day again? You don’t know for sure. And what is going to happen anyway when it starts to adjust? Will it go up or down? How much will it move? Is there any rhyme or reason to the “adjustments?”
How Adjustable Rate Mortgages Work
For the Adjustable Rate Mortgage (ARM) product, interest is fixed for a set period of time, and adjusts periodically thereafter. At the end of the fixed-rate period, the interest and payments may increase. There are 4 main variables to pay attention to:
- Margin: The margin is a fixed “base” that will determine your rate after the fixed-rate period. When your rate starts adjusting, the margin is added to the index to come up with your new interest rate. Rates can vary from loan to loan, but the most common margin is 2.25%.
- Index: The Index is the adjustable part of your rate after the fixed-rate period is over. The index is a rate that fluctuates with market movement. There are an array of indexes that can be used, but the most common index for adjustable rate mortgages in the US is the 1 Year LIBOR.
- Adjustment Periods: Most current ARM loans come with an initial fixed-rate period, followed by adjustments at certain periods. The most common is a 5 year initial fixed period followed by adjustments once per year. Other loans include 1 year, 3 year, 7 year and 10 year fixed periods. Adjustment periods can also fluctuate every 6 months, and even monthly on some loans.
- Caps: The caps are limits on how much the rate can move up or down each time it adjusts. Some ARM loans have an initial cap, subsequent adjustments caps, and a lifetime cap. For example, if the index goes up dramatically, your rate may only adjust slightly if you have low caps.
If I get an 5 year ARM loan, do I have to pay it off in 5 years?
The quick answer is no you do not. Most ARMs are 30-year term loans. A 5 year ARM is a 30 year loan with a fixed interest rate for the first 5 years, and an adjustable rate for the remaining 25 years. Your rate can fluctuate during the last 25 years, but as long as you keep making your monthly payment, you are free to keep the same loan for the full 30 years.
What happens when my ARM starts adjusting?
After your initial fixed period is over, what happens is your rate will adjust to the current market based on your margin, index and caps. The simple math is:
Margin + Index = Interest Rate
For example, if your margin is 2.00% and the index is at 2.50%, your rate will be 4.50%.
If, in the same scenario, your initial fixed rate was 3.00% but your loan has an adjustment cap of 1%, your new rate would only go to 4.00%. Simple as that!
Does my rate always go up?
During the adjustable rate period (the last 25 years of a 5 year ARM loan), your rate will go up or down based on market conditions. Each time the rate is up for adjustment, the current index value will be added to the margin to determine your new rate. In the above example with the 2.00% margin, if the index value was 1.00% on adjustment day, the new rate would be 3.00%.
Should I get rid of my ARM loan?
As with all financial decisions, it is important to study out the costs and benefits before making a move. If you are losing sleep because of an impending feeling of doom over the future potential adjustments, you should seriously consider refinancing to a fixed rate. Peace of mind is not a financial benefit, but it certainly is a benefit!
Check with your servicing lender first, because some ARM loans come with a fixed-rate conversion feature that may allow you to convert to a fixed rate without refinancing. This may potentially save you money.
What are my options when my loan is about to adjust?
Choose the option that fits your needs:
Switch to a Fixed.
You can refinance to a stable fixed rate. That gives you consistent payments for the entire life of your loan and saves you from every worrying again about changing mortgage rates. A fixed rate could be a smart choice if you plan on staying in your home long term or want to take advantage of low interest rates.
Go Adjustable Again.
You can refinance to another adjustable rate mortgage. If you know that you’ll want a different home soon, or relocation is on the horizon, another ARM loan will usually save you more in the short term versus a fixed rate.
Wait and See.
You can choose to take no action. If you don’t refinance your mortgage, your servicing lender will let you know your new rate and payment. If you are comfortable with the new payment, you are free to keep the same loan and ride it out! Many borrowers have taken advantage of historically low interest rates and seen their mortgage payments go down consistently. That will not always be the case, but remember all the money you saved during the initial fixed rate period and you may still have made a wise financial decision!
The bottom line
There is no one blanket correct answer here. Because your situation is uniquely yours, contact us today for a free personalized consultation. We will explain your options and help you make an informed decision!