A Fixed Rate Mortgage is the most common type of loan: The rate and payment is fixed for the life of the loan, depending on the fixed term you choose, with no opportunity for adjustment. An ARM is fixed for a set period of years (typically 5, 7 or 10) and then adjustable for the remaining loan term. ARMs tend to go in and out of the market – in recent years, they were not competitive at all and therefore made no sense against a fixed loan. But they are back now, and fairly aggressive, so when coupled with higher market rates and expensive housing, many homeowners are electing to take on some of the risk.
So what is an ARM and how does it work?
An ARM is fixed for a set amount of time (the introductory period) and then adjustable for the remaining life of the loan. Current ARM options are a 5/6, 7/6 or a 10/6. The 5/6 is fixed for 5 years and then adjustable every 6 months for the remaining 25 year term, the 7/6 is fixed for 7 years and then adjustable every 6 months for the remaining 23 year term, and the 10/6 if fixed for 10 years and then adjustable every 6 months for the remaining 20 year term.
There is no risk during the introductory period since that interest rate and payment is fixed, but the risk does come once it enters its adjustment period. So if an ARM sounds attractive to you for rate and payment, what you need to ask yourself is:
- How long do I anticipate owning this home?
- How does an ARM affect my affordability?
- What is my comfort level when my ARM enters its adjustment phase, if I haven’t yet refinanced into another fixed term? Can I manage an increased payment?
ARMs do have “caps”: (1) an initial adjustment cap; (2) a subsequent adjustment cap, and (3) a lifetime cap. As a demonstration of what this means, let’s just say you chose a 7/6 ARM where the Note Rate is 5.0% for the first seven years of the loan, and the caps are 5/2/5. Broken down, what this means is that in the 1st year’s adjustment, the rate can be no higher than Note Rate + 5%, so max of 10.0%. In subsequent adjustments, the rate can never exceed more than 2% above the previous adjustments. So let’s say your rate at that very 1st adjustment ended up actually being 6.0%. After that 1st 6 months, the next subsequent rate would not exceed 8.0%; and after that, it would not exceed 10.0% … And the lifetime cap is 10.0%, so you know your rate would never go past that.
Bottom line is that an ARM can be a great tool for the right person, but the product’s risk versus reward is something you must be fully informed about and comfortable in securing.