How Does an ARM Mortgage Work

An adjustable rate mortgage is synonymous with risk, and most homebuyers veer away from it. Think back to the 2008 crisis and many remember that thousands of homeowners lost their homes. ARM mortgages are still around today. In fact there are certain types of buyers who might actually want to find out more. It's just a matter of understanding exactly how this type of mortgage functions. We are going to go into detail of what an ARM mortgage is, how it functions, and who it is primarily for.

An Adjustable Rate Mortgage Defined

Your conventional mortgage is the most widely understood. The monthly payment remains a constant and won't ever change. This is probably the safest type in the marketplace today as there are zero unknowns.

When we think about the adjustable variety, the interest rate on the mortgage can change. Your ARM mortgage will start out with a fixed term. This might be one year, or it could be 3, or even 10. It all depends on the type you choose. After this initial term expires, your rate probably will reset. These are called adjustment periods.

Now you might be thinking why anybody would ever agree to this type of mortgage. Let's be clear. The only reason anybody would ever want to engage in this is for the lower initial interest rate. You see, the ARM mortgage will come initially with a lower interest rate than its conventional brethren. This means your payment is lower and you will save money. Your credit score will go a long way in determining what type of rate you can qualify for.

Also you should know that rates can go up and DOWN. Yes this means the payment on your mortgage could decrease. This means your mortgage payments would go even lower. We have been in such a period of low rates, that they must at some point go up. Don't count on your rate to go down in other words.

Remember that your ARM will be tied to a mortgage index. This is the benchmark and will determine if your rate increases or decreases. Don't worry, the lender will have to show you which index your rate will be tied to.

Caps and Indexes

Now built into every one of these mortgages are caps. This is to protect the buyers from payment shock! Here is how ARM caps work.

Initial Rate Cap: Now after your initial teaser period expires, your rate can move. But there will be a ceiling.

Next Adjustment: Remember adjustable rate mortgages will probably have multiple adjustment periods. There will also be another adjustment for the next period, and the next period after that, and so on. Each period will have a maximum cap.

Lifetime Cap: A maximum rate increase will also occur on the life of the loan. So if your rate ever reached this ceiling, your rate couldn't go up anymore.

Real Life Examples

Let's go over some real life examples to help you better understand.

Imagine you have an ARM mortgage with an initial interest rate of 1.5%, a periodic rate cap of 1%, and a lifetime cap of 4%.

Let's suppose rates spike and the margin rate increases to 5%. The initial period has ended and your new rate will be 2.5% because of the 1% periodic rate cap.

It can only go up 1% each period, and will max out at 4% because of the lifetime cap.

An ARM mortgage calculator will show you an example so you can see just how much your payment could go up or down.

3/1 ARM

This is one of the most popular varieties. Your initial teaser period is for 3 years. Your rate and payment won't change. Starting the 4th year, your rate can reset. And it will reset EACH year until you sell your house, or pay off your mortgage. If you have a 30 year mortgage, you will have a number of adjustments.

3/3 ARM

Again the initial period here is for 3 years. Starting the 4th year, the rate will reset and remain there for an additional 3 years. So your adjustment periods will include years 4, 7, 10, 13, 16, 19, 22, 25, and 28.

If rates spike during the middle of year 4, you wouldn't feel any impact until the beginning of year 7. But the opposite is also true. If rates dropped during that same time frame, they couldn't adjust down until that period became available.

Who an ARM Might be for and Who Should Avoid It

Remember the only reason that you might want to inquire about one is for the lower mortgage payment. 10 year ARM's do exist in the marketplace. That would mean you would have a fixed mortgage rate for at least 10 years.

It's easier to start out with who should avoid this type of mortgage.

• Someone on a fixed income. They know they won't be making anymore or any less than they are today. There is a limit on how much they can afford.

• A buyer who intends to live in their house for a very long time. We mean 15 years, 20 years, or even for the rest of their life. If this is you, there is no reason to assume any risk. Take your conventional mortgage and move on with your life.

Now let's discuss where an ARM might make more sense.

• You never live in a home for more than 3-5 years. If this describes your lifestyle then it might make sense for you to take the lower payments, because you will sell the house before the rate resets higher.

• You will be making more money in the future.

• The area you will be buying your home in will be worth more in 2-5 years than it is currently. This situation would be for a seasoned investor or someone with extensive knowledge. They would be able to sell their home before the first interest rate hike.

An ARM certainly is valid and has it's place in the marketplace today. But again, it's ver the savy homebuyer who understands the risks. If you have no risk tolerance, go with the conventional mortgage.