Why an ARM?
Fact is that the average American gets a new mortgage once every seven
years. Maybe you're buying a starter home or you transfer a lot with
your job or you plan to pay your mortgage down significantly over the
next 5 to 10 years. For whatever reason, you probably won't need a mortgage
for 30 years. Even if you're not sure how long you will own your home,
if you don't think you'll be there 30 years you probably don't need a
30-year fixed rate mortgage. That's because when you move, you'll need
to get another mortgage. And when you do, your mortgage rate will be
whatever rates are at that time.
We know. We hear it as much as you do. "30-year fixed rates are at historic lows." But so are rates on ARMs. And ARM rates can be almost 2 percentage points cheaper than 30-year rates. Reality is that 30-year fixed mortgages are some of the most expensive mortgages available. Instead of paying the same high rate for 30 years, pay a lower rate for a mortgage that has a fixed rate for a shorter time. Ideally, you want to fix your rate for the amount of time you will actually live in your house or plan to pay off your mortgage.
See how much you can save
The chart shows how much less you will pay in interest using a 5/1 adjustable rate mortgage as an example.
Chart based on $175,000 mortgage. Interest and principal amounts are from the first five years of the loan, based on interest rates for the Orange Mortgage 5/1 ARM (4.00%) and the national average 30-year fixed rate mortgage with no points (5.553%) as of 3/11/2004.
If you pay extra for a 30-year fixed term when you don't need a term anywhere near that long, the extra interest you pay every month is wasted.
How an ARM works
Adjustable Rate Mortgages have a fixed rate for a specified
period of time, usually between 1 and 10 years. After the
fixed period, the rate can adjust. For example, if you see
a mortgage that's a 5/1 ARM, the first number, 5, is the
number of years the initial rate stays fixed. The second
number, 1, is how often the rate can adjust after the 5th year,
in this case, annually. (So a 3/3 has a fixed rate for
3 years then adjusts every 3 years after that.) Just
like with a fixed-rate mortgage, you can still plan to
pay the mortgage off over a long time, up to 30 years,
but the rate is initially fixed at a lower rate for a
shorter period and then it adjusts annually after that.
The Adjustment Period
Banks can't just change the rate after the initial fixed
rate period to whatever rate they like. The rate adjusts
based on a financial index.
Banks then add a margin that is specified upfront and
stays constant. So if the 1-year Treasury Bill at the
end of year 5 of a 5/1 ARM is 1.75% and the bank's margin
is 2.50%, your rate for year 6 would be 4.25%. The rate
can be higher, lower or the same depending on where the
Treasury Bill is. Every year after that, the mortgage
automatically adjusts at the Treasury Bill plus the margin.
Rate Caps
It sounds like rates can still change a lot once the
initial fixed period ends but there are usually both
annual and lifetime maximums, or "caps",
on how much the rate can change. With the 3/1 Orange
Mortgage, the rate can adjust - up or down - a maximum
of 2% annually after the fixed term ends, and 6% over
the life of the loan. On a Mortgage the
initial rate can adjust - up or down - a maximum of
5% in the first year after the fixed term ends, and
then 2% annually with a maximum, or cap, of 6% over
the life of the loan. The important thing to remember
is that your rate can go up, down or stay the same.
It can change annually after the fixed period only
if the 1-year Treasury Bill changes.
A great way to save money is to pick a term for the ARM that is close to the time you'll need the mortgage. Let's say you expect to be in your house less than 7 years or plan to have your mortgage paid down significantly within that time. Rather than wasting money paying a higher rate for a 30 or even 15-year fixed mortgage, choose a 5/1 ARM, where your rate is set for 5 years - and then adjusts automatically each year based on the Treasury Bill rate after that. If you move, you can shop around for the very best mortgage for your new house. Once again, it will probably be an ARM.