How Does An Adjustable Rate Mortgage Work

If you are considering purchasing a home or refinancing your existing mortgage and you only plan on being in your residence for less than seven to ten years, then it may make sense to consider an adjustable rate mortgage. Often referred to as ARMs, adjustable rate mortgages have introductory interest rates which are set for a designated number of years before then adjusting based upon the movements of an interest rate index which the loans are tied too. Some commonly used indexes which ARMs use include the 1 Year Treasury Rate and the 1 Year LIBOR (London Interbank Offered Rate).

When shopping for adjustable rate mortgages, consumers should make sure that they have a firm understanding of the loans' margin, its associated index, the adjustable intervals, and the caps for the adjustments. Consumers should also be aware that the first adjustment may be potentially larger than that of future adjustments.

For example:

A loan officer quotes a 3/1 LIBOR ARM with a start rate of 4.000% and a 2.25% margin and a initial rate cap of 3% and then annual rate caps of 2% for every year thereafter. In this scenario the intro rate would be set a 4.000% for the first three years of the loan. On the 37th month, the loan would adjust by adding the loan's margin (2.250%) to the current index rate (say 1.250%). The result would be the "fully indexed rate" of 3.500%. In this scenario a person would actually see their rate decrease on the initial adjustment. Depending upon the current index rate, the loan may be limited in its first adjustment by the 3% cap limit.

Should One Consider an Adjustable Rate Loan?

ARMs do carry a higher degree of risk and it is essentially up to consumers to determine whether the rewards outweigh the potential risks. The first step is to examine how much lower current ARM rates are than fixed rates and determine how much savings there may be in the introductory rate period. Unless the ARM rates and savings are extremely attractive, the consumer may want to play it safe with a fixed rate mortgage program. Adjustable rate mortgage borrowers should also feel confident in their ability to refinance before their loan's first adjustment and that the real estate values in their communities are in a stable or appreciating environment. The last thing a homeowner wants is to be upside down on their home loan and stuck in an ARM without the ability to refinance.