Ask Renee: Understanding ARMs

Good morning, this is Renee Han with Downing Fry Realty. This is a series I call Ask Renee where I tackle some of the more common questions that come up from buyers and/or sellers in the real estate space and give you short segment answers. Today what I want to talk about is the ARM. I don't mean this arm, I mean an adjustable ARM mortgage loan. Every now and again I'll get questions on whether it is appropriate or good to use an ARM, an adjustable rate mortgage, or go with the standard 30-year fixed traditional loan. I always advise that people talk with a mortgage lender to make sure that you've got the latest in terms of what types of loans are available and what would be a best fit for you in terms of your your financial needs and your purchasing needs. However, I thought it was worth spending a few minutes to talk about what an adjustable rate mortgage is. An ARM is just that. What it's doing is it's allowing you to take advantage upfront on a lower interest rate, and then the mortgage lender has the opportunity to adjust that rate to bring it in alignment with changes in the interest rate. So typically you can get an ARM for a lower interest rate up front than you could on a traditional 30-year fixed mortgage. Now there are different types of ARM loans. You can get them— uh, 7/23 is a popular one where for the first 7 years it's a low fixed rate and then it adjusts in the remaining 23 years over a 30-year loan. There are also 1-year ARM adjustables, 5-year adjustables. Again, the whole concept is that you've got a fixed rate for a short period of time, and then over the length of the loan, the rate becomes adjustable. So some of the things that I always suggest doing is, you know, looking at— first of all, always, always, always compare across a a couple different mortgage companies what they're offering in terms of the framework of the loan as well as the terms of the loan, um, including interest rates. So determine the initial interest rate. If it's a defined rate on which your loan will be based in the initial period, figure out whether that initial term is 1 year, 3, 5, 7, or even 10 years. Then you want to do is ask if the ARM is based on a negative amortization schedule. Although my experience is that most ARMs currently are not amortized on a negative basis, every now and again I still find that there are loans with a negative factor built in. What this means for you is that although you may be paying a lower interest rate for the first few years, let's say it's, you know, for the first 2 to 3%, The interest is still being charged on your loan at a higher rate. So this is really important. It might be 4 or 5%. The interest, you know, in this case rather, the extra interest payment, the difference between what you are paying and what is being charged to you, is added to your mortgage balance. So that's obviously something that you're going to want to know about because your mortgage balance, instead of paying down the principal could be having that added in. And under no circumstances, you know, would I actually recommend you getting into a mortgage that has a negative amortization schedule. So that's another thing you're going to want to look at. Determine what the rate adjustment will be. Find out if there's a cap on the periodic increases and determine what index the lender will use as a basis for calculating the changes in interest rates. So oftentimes they may say it can increase up to X percent at any given year. They'll also tell you what they use as their benchmark. Generally, lenders are going to use one of three indexes. They're either going to use the weekly average yield on Treasury bills, which is published by the Federal Reserve Board. They're going to use the 11th District Cost of Funds Index. That's also called the DOFL, or they're going to use the LIBOR, which is the London Interbank Offered Rate. The lender, what they'll do is then they add that to the index number, a rate adjustment called a margin. And if the adjusted rate is higher than the old one, then when your adjustment period comes due, your interest will be modified according to the next set of payments. Now, every now and again, we've actually— I had a 5-year adjustable loan on one of my own investment purchases that we had intended to get rid of sooner than we actually did, and this was when the economy went— it kind of tanked. But there were periods of time where our adjustment actually stayed the same or came down, but that's a big risk because it certainly could have gone up. Another point to consider is whether there is a ceiling on the overall amount that your rate can increase. Lenders realize that an ARM without such a ceiling you know, as a potential disaster for consumers because that means that there is no limit to how much your interest rate could increase. So for example, if you start with a 3% loan and there is a 2% cap on the yearly increases, it's conceivable that at the end of the 5th year you would be facing a mortgage rate of 13%, which is obviously a lot higher than the 3% that you started with. Most lenders are putting an overall ceiling on your interest rate, um, and it's usually limited to 5 to 6, uh, percentage points. Thus, your initial rate is 3%, and the most you'll ever pay is 8 to 9%. Again, make sure that you understand what the ceilings in the loan arrangement are, and then get them in writing before you commit yourself to any adjustable rate mortgages. Um, the other thing is there are serious problems sometimes with interpreting how the rate adjustment works after you get a loan. Anyone with an ARM is advised to carefully review the original loan documents to determine whether the lender has properly and correctly addressed the new adjustment rate when the adjustment period comes due. Keep in mind, depending on the cap, at some point in the future you may be required to make more monthly payments than you can afford. So again, with any decision on taking out a considerable sum of money in the form of a loan, you should make sure that you've done your shopping around to compare programs and rates, but that you have also read all the fine print and understand completely how your loan terms will work, both on the front end as well over the course of the loan. So I advise you, if you have any deeper questions, feel free to reach out to me, and I'm happy to put you in touch with a couple lenders that I found to be very reliable and professional and good at what they do. If you've got any real estate related questions, don't hesitate to reach out to me at 239-287-2576. Again, this is Renee Han from Downing Fry, and I hope you have a fantastic day.