When you're shopping for the lowest mortgage rates available, an adjustable-rate mortgage (ARM) can seem attractive. However, the low rates an adjustable-rate mortgage offers now can potentially cause problems later. Here's why.
Adjustable rates: Why are my payments going up?
Adjustable-rate mortgage loans (ARMs) are defined by the fact that the interest rate isn't fixed throughout the life of the mortgage. Depending on the terms of the loan, the initial starting rate may apply for a period ranging from one month to 10 years. Once that period expires, the rate converts to a variable rate and what you pay is determined by several factors. Adjustable mortgage rates move with financial markets and are pegged to published financial indexes. When these indexes increase, so do rates.
Adjustable mortgage rates, caps and margins
Other components of ARMs include "caps" and "margins." Caps limit the size of a rate increase and can also limit how high a rate can go during the life of the loan. There are additional caps limiting how low a rate can go -- these are usually called "floors." The margin of a loan is a percentage added to the index and represents revenue to the lender. Subject to any applicable caps, the margin plus the index equals your interest rate. This is also referred to as the "fully indexed rate."
Example of an interest rate adjustment
Here is an example of how ARM interest rates can adjust: Mr. Borrower was granted an ARM that offered a fixed rate for three years and then converted to an adjustable rate. His starting rate was 4 percent, the loan was based on the six-month LIBOR index and carried a 2 percent margin. On the day his rate is set to reset, the LIBOR is 3.48 percent. Adding the 2 percent margin to this rate equals a fully-indexed rate of 5.48 percent. Mr. Borrower will pay 5.48 percent on his loan until its next reset, when the rate will be recalculated.
How lower mortgage rates can lead to higher loan amounts
In the interest of offering affordable mortgage loans, lenders developed loans that included extremely low monthly payments. Sometimes the payment amounts weren't even enough to cover the full principle and interest (P&I) payment. In these cases, the shortage is added to the mortgage balance. As concerns about credit and home values escalated after the last housing crisis, lenders largely ceased offering these types of mortgage loans. Still, before deciding on your next mortgage, you'll want to be sure you're not getting a loan that could put you deeper into debt each month.
If you plan to sell your home soon, an ARM with a very low starting rate could be a good deal -- you probably won't have the loan when the rates adjust higher. Considering the unpredictability of recent housing markets, however, it's good to build in some flexibility. If you're planning to sell your home within five years, you might want to shop for hybrid ARMs that won't reset for seven years, instead of an ARM that will change in five years.
Understanding all of your mortgage terms can help prevent problems if your plans change. Asking potential mortgage lenders questions is a good way to understand how the mortgage rates on a particular loan can adjust.