Adjustable Rate Mortgages (ARMs ) - Advantages and Disadvantages
By: Adam VanBuskirk
An ARM is a mortgage that has an interest rate that adjusts periodically, often every six or 12 months. At these intervals, the interest rate is adjusted using an index and a margin. The index is a financial index that is used to gage general interest rate trends. Treasury Bills (T-Bills), Certificates of deposit (CDs), The 11th District Cost of Funds Index (COFI), and others are examples of financial indexes that are often used to determine interest rates. The margin is the markup that the lending institution places on their loans; put bluntly it’s the cost that they charge borrowers to use their money. The index is then added to the margin resulting in the interest rate the borrower pays.
With a brief explanation of the ARM laid out above, the following is a list of both advantages and disadvantages of financing a property using an ARM.
ADVANTAGES
1.) Saving Money - An ARM's initial interest rate is always lower than the interest rate of a similar-term fixed mortgage. If the borrower can financially afford the risk of future rate increases, then it may make since to get the ARM and save money by paying a lower interest rate. ARMs usually have a lower rate than fixed mortgages for approximately one to two years before the ARM’s rate increases propel it higher than the fixed rate (if mortgage rates are increasing).
2.) Rates are Currently High - If rates are currently through the roof, then an ARM makes since if one is betting on dropping interest rates. By getting an ARM when rates are high, the borrower takes advantage of two things. First, if the interest rate starts to fall, so will the borrower's monthly mortgage payment without them having to refinance. Secondly, the borrower profits for the first year or two because the teaser, or initial interest rate, will be lower than that of comparable fixed-rate mortgages.
3.) Assumability - Often an ARM contains assumability; the ability for the loan to be "assumed" by the new buyer of the property from the current owner of the property/loan. This is a huge benefit if interest rates are high because the ARM will shift down with the interest rates after the rates peak and start to move downward. By assuming the old owner's ARM, the new owner saves themselves from getting pinned down with a ridiculously high fixed rate mortgage that will have to be refinanced if rates drop.
4.) No need to Refinance if Rates are Dropping - Fairly self-explanatory, the owner of an ARM does not have to refinance their mortgage if interest rates are dropping. Instead, their monthly interest and overall payment will drop at each scheduled rate evaluation. If the borrower had a fixed-rate mortgage, they would have to qualify and pay to have their loan refinanced to a lower rate.
DISADVANTAGES
1.) Negative Amortization - Put very, very simple, the monthly mortgage payment of the ARM has a cap on it, but the monthly interest rate increase does not. If one has a $500.00 max monthly payment and is currently paying $500.00 their payment is maxed. At the same time, if the loan's rate is evaluated and increased by 1% per month, this 1% is not added to the monthly payment of $500.00, because it is already at the monthly maximum payment. This means that each month 1% will be added to the ARM balance, thus every time one pays their monthly mortgage payment the loan balance is actually increasing. Put simple, the mortgage has essentially turned into a credit card.
2.) The Teaser Rate - The teaser rate is the initial monthly interest rate that is advertised for the ARM. This rate is lower than the interest rate found on a comparable fixed-rate mortgage, but not for long. After a term lasting anywhere from a couple of months to a couple of years, the teaser rate disappears and often the interest rate of the ARM has surpassed that of the fixed-rate mortgage. If one is prepared this is not a huge deal and is even expected by the borrower. But the trouble here lies within the fact that often inexperienced borrowers are the ones that most often fall for the teaser rate, not aware that the rate will not last long. When considering an ARM, don't evaluate it based on the teaser rate; rather use the index that is used for adjusting the ARM and the margin that the loaning institution requires. See the top of this article for an explanation of the loan’s index and margin.
3.) Rates are Low and going Up - Sound familiar? It should, this is the situation that the United States currently faces. Many people are currently using ARMs to speculatively purchase homes and then resell them for a profit before the interest rate increases, thus creating the infamous United States real estate bubble that everyone is talking about.
Don’t fall into this trap! With rates currently low and rising every time the Federal Reserve meets, borrow a fixed-rate mortgage when purchasing a property. This ensures that as interest rates continue to increase, the borrower’s monthly payment will not. It also eliminates the need to refinance the loan after rates have increased significantly.
The author is the founder and owner of LandLordDocuments.com
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