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8 Questions to Ask Before Choosing an Adjustable-Rate Mortgage

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If you’re comfortable with some financial risk, this loan might be the perfect fit.

It can be intimidating to even think about getting an adjustable-rate mortgage (ARM). There’s so much to know.

And there was that pesky little mortgage crisis a few years back where many people with ARMs got pretty burned. But don’t discount an ARM before you know all the ins and outs. If you’re comfortable with risk, an ARM might be right for you.

We’ve broken down the most important aspects of an ARM so that you can determine whether one is right for you. It’s as easy as 1-2-3: index, margin, and caps — oh, my.

1. How does an ARM work?

When you take out an ARM today, it won’t be a purely adjustable rate. Instead, you’ll be offered a hybrid ARM.

“These are loans which start with a fixed rate for a specific period, such as three, five, seven, or 10 years,” says Joe Parsons, senior loan officer at PFS Funding in Dublin, CA. “The shorter the initial fixed period, the lower the start rate.”

“If you don’t see yourself living in a home forever, an ARM is a good option to consider,” says Heather McRae, senior loan officer for Chicago Financial Services Inc.

Why do borrowers like them? Your starting interest rate will be lower with an ARM than with a fixed-rate loan.

Let’s consider this example from Parsons: Say you’re taking out a 30-year fixed-rate loan of $300,000 with a 4.125% interest rate. If you were to take out a 5-year ARM, the equivalent interest rate would be 3.625%. That means you would save $70 a month on your mortgage payments.

2. What is an index?

After the fixed-rate period is over, your interest rate adjusts based on the index the lender uses. There are several indexes. The most common ones are the Constant Maturity Treasury, 11th District Cost of Funds Index (known as COFI), and the London Interbank Offered Rate, or LIBOR.

“The value [of the index] changes from month to month and can be found in the financial pages of most newspapers or online,” says Parsons. Look at the rates of the common indexes for some idea of how they performed in the past.

3. What is a margin?

We just said that your interest rate adjusts depending on the index. But the story doesn’t end there.

Lenders add a margin, which is a fixed percentage rate added to the index. The margin is set at the start of the loan, and it never changes. You need to know what the margin is to determine whether you can handle the payments when your loan adjusts.

Here’s another example from Parsons: Say your index is LIBOR, which has a value of .86 on the day your loan adjusts. You have a margin of 2.25. Your new rate would be 3.11% — and you would celebrate. Your loan rate would have gone down if you had started at 3.625%, meaning a lower mortgage payment for you.

But here’s where you should plan for the worst and hope for the best: Chances are good your rate will go up instead of down.

4. What are caps?

To keep the ARM from being the Wild West of the financial world, caps are in place: the initial cap, the annual cap, and the life cap.

Your caps would be displayed like this: 2/2/6 or 6/2/6, for instance. The first of these examples is less risky than the second, explains Heather McRae.

Here’s why: “The first of those three numbers is the maximum the interest rate can go up on the first adjustment,” she says. So in the first example, if your start rate was 3.25%, the max it could go to would be 5.25% on the first adjustment.

“The second number is the cap for every subsequent adjustment the rate can increase by above the rate during the previous period,” says McRae.

The second number in both our examples is a 2. Let’s say your rate adjusted to 3.75% from 3.25% during the first adjustment. When your ARM adjusts next (usually in a year), it’s capped at 2%. So 2% plus 3.75% is 5.75%.

The third number in both examples is 6. “This means the rate can never go higher than six points above the start rate,” says McRae. So if your starting rate was 3.25%, your rate could never go higher than 9.25% in this example.

5. How often can your loan adjust?

After the fixed-rate period is up, your loan adjusts regularly. Most adjust once a year, but the period could be shorter or longer.

Here’s how you can tell: say you got a 5/1 ARM. That would mean your loan would be fixed for five years and would then adjust every year. And a 5/6 ARM? This one is fixed for five years but adjusts every six months.

6. Will I have a prepayment penalty?

In a word: no. “Prepayment penalties on home mortgages are essentially nonexistent,” says Parsons. And prepayment penalties are never allowed on ARMs, according to the Consumer Financial Protection Bureau.

7. So what is the drawback of an ARM?

You don’t know whether your rate will go up. If you’re not a gambler, you might not want an ARM.

“If there is a possibility that you’ll lie awake worrying about what the rate will be in five years, don’t get an ARM,” says Parsons.

8. And what is the benefit?

The main benefit is the lower starting rate. “An ARM can be a very good choice for a buyer who only expects to own the home for a shorter period of time,” says Parsons.

Have you chosen an ARM for your home? Why or why not? Share your experiences in the comments below!