When it comes to getting a mortgage there are some immediate questions that come to mind regarding how you want to structure the loan. Are you looking for a fixed rate, or adjustable rate mortgage (ARM)? Meanwhile, further variances include options such as 7/1 ARM and 5/1 ARM. If you’re not familiar with these terms it can be very confusing, as each comes with a set of benefits and risks.
Perhaps the most popular of the options is the fixed rate mortgage. The concept is quite simple here- the interest rate stays the same through out the term of the loan. When the interest and principle remain the same, your monthly payment will stay the same through out the term.
The only drawback of a fixed rate mortgage is that the interest rate is generally higher then it’s adjustable counterpart. Think of it this way: with a fixed rate mortgage you are paying a little bit more for security and peace of mind.
That brings us to the adjustable rate mortgage (ARM). With this type of loan set up, the monthly payments can change as the interest rate fluctuates . Usually, there is an initial fixed rate period that will be followed by rate changes at pre-set intervals.
These intervals are agreed upon prior to the inception of the loan. The most common split is the 5/1 ARM, which means that the initial interest rate will last for five years. Following that period the interest rate will change yearly. The “5” refers to the length of the introductory rate, while the “1” refers to how often the rate will be subject to change.
Using this logic it’s now much easier to understand what a 3/1 ARM, 7/1 ARM, and 10/1 ARM all mean. That is respectively three, seven, and ten year introductory fixed rates, with yearly rate changes following in all cases.
In the case of a 5/6 ARM, the rate can change every 6 months.
To complicate things further, you can find offers such as 3/27, which is three years fixed rate followed by 27 years of rate adjustments.
Or even a 15/15 ARM which, is subject to only one rate change halfway through the life of the loan.
The benefit of an ARM is the initially lower interest rate, with a chance that the interest rate may get even lower, resulting in even lower monthly payments. However, on the flip-side there is always the risk of rising interest rates, as they can be quite unpredictable.
How the adjustable interest rate is calculated
After the introductory period the interest rate is subject to change based on the performance of a specific index, which is tied to the cost of borrowing incurred by the lender.
Only one index is chosen for the ARM performance, but there are many indexes to choose from. The most popular indexes are as follows:
- LIBOR (London Interbank Offered Rate), the international interest rate between banks on large loans
- COFI (11 th District Cost of Funds), the rate in which western US financial institutions are paying on their deposits.
- or MTA (Monthly Treasury Average), the yield of debt securities issued by the US Treasury.
The second variable of the adjustable rate mortgage is the margin, which can vary up to 1% by lender, is equally as important as the index that the borrower selects. The margin is a pre-defined amount of percentage points that will be added on to the index to set the ARM rate . Unlike the index, the margin will never change throughout the life of the loan.
For example: Today’s LIBOR rate is 1.77%, while the margin agreed upon with the lender is 2.25. Since you’ve passed your introductory period, your new interest rate for the next year would be 4.02%.
This is why choosing the right index, and the right lender for the margin, are of extreme importance. It is best to do your research on the performance of different indexes to choose the most suitable option.
It’s not as volatile as it seems though, as there are precautions put in place to cap payments and interest rates. So luckily, the sky is not the limit here. There is a cap on the initial adjustable rate, the periodic adjustable rate, and the lifetime rate change . Therefore your rate can neither drop below any of these points, nor exceed these points.
The most common structure for these caps is 6/2/6. This means that the rate can change up to 6% once it becomes adjustable, only by 2% per adjustment (most cases yearly), and by 6% total through the life of the loan. While this may be relieving, a 6% rate change is still a huge spike, and can steeply increase payments in the blink of an eye.
It is also harder to qualify for an ARM, then a fixed rate mortgage, as there has to be some contingency for the possibility of greater monthly payments, or worst case scenario
Most homeowners choose this type of loan for the lower initial payment, then usually refinance out when the fixed period ends, or sell the home. We will talk more about refinancing in our next homebuyer segment.
The final variable we will review in this post is quite a bit easier to understand then the mechanics of an adjustable rate mortgage, which is the amortization schedule.
Amortization is the term that describes the length of the term repayment. You can get a 15 year amortization, or 30 year amortization, which is really as straight forward as it sounds. That is respectively 15 years to pay back your loan, or 30 years.
Basic logic will tell us that to pay back a loan in 15 years vs 30 years of the same amount will require higher monthly payments, but also subject us to less total interest paid and higher equity in the home as well. Instead of 360 months of mortgage payments, you will only have 180 months of mortgage payments and only be subject to half the amount of interest payments.
With a 15 year amortization you can save hundreds of dollars per month in interest, but instead pay more in principle payments. It may seem like an obvious choice, but can be more complicated depending on leverage and tax deductions. It may also be difficult to afford such a high cost monthly payment.