If you are shopping for a mortgage, and you’ve decided you want an ARM (adjustable rate mortgage), here are three things you must look at:
Why is this information important? Because ARMs work like this: they have an initial period that’s fixed for 5, 7, or 10 years. After that initial fixed period, they will adjust every year. Thus a 5 Year ARM is often called a “5/1” because it adjusts every year after the fifth year. The payments are based on a 30 year amortization, so they’re low like a 30 year fixed. But after that initial period, ARMs start to adjust. How they adjust is what you need to focus on if you’re choosing an ARM.
What is an index?
An index is what lenders look at when they determine your new interest rate. A common index is 1 Year LIBOR (London Interbank Offered Rate). Another index that’s less common is the 1 Year Treasury.
What is the margin?
The margin is what lenders add to the index to potentially determine your new interest rate. If the current 1 Year LIBOR is at 3.00% and the margin on the ARM is 2.25%, your new interest rate is theoretically 5.25%.
What are the caps?
The caps protect you against the rate going up. There are three caps:
- Initial cap
- Period cap
- Lifetime cap
What does the initial cap do?
The initial cap limits how much the interest rate can go up on the first adjustment. Let’s say you take a 5 Year ARM at a rate of 3.50%. That rate stays the same for 5 years. This ARM has an initial cap of 2%.
It is now the end of Year 5. The index (1 Year LIBOR) is currently at 4.00%. The margin is 2.25%. The lender adds the index + margin and gets a new rate of 6.25%. Can your rate go that high? NO because you have a 2% cap. What does that mean? It means your rate in Year 6 cannot go higher than 2% over the initial interest rate. Your initial interest rate was 3.50%. If you add the 2% cap, your new interest rate in Year 6 cannot be more than 5.50%.
What does the period cap do?
The period cap works like the initial cap, but it governs the maximum interest rate increase after the first adjustment. In plain English, with our 5 Year ARM, the period cap limits the increase every year after Year 6. For our example, let’s assume the period cap is also 2%. And let’s assume your rate went to 5.50% in Year 6. Now we’re at the end of Year 6. The current 1 Year LIBOR has shot up to 7.50%. Once you add in the 2.25% margin, your new rate could potentially go up to 9.75%. Will it? NO because the 2% cap limits your rate to 2% over the rate in Year 6. The rate in Year 6 was 5.50%, so your new rate in Year 7 is 7.50% regardless of where the 1 Year LIBOR is.
What does the lifetime cap do?
The lifetime cap, as its name implies, limits the amount of increase in the interest rate over the life of the loan. With our theoretical 5 Year ARM, let’s assume the lifetime cap is 5%. That means over the entire life of the loan, your rate can never go higher than 5% over the initial interest rate of 3.50%. So no matter where rates go, your rate will never be higher than 8.50%.
What does this all mean for you?
If you’re shopping for an ARM, you should compare ARMs with the same index, margin, and caps. Because if one 5 Year ARM has a 2% initial cap and another 5 Year ARM has a 5% initial cap, you have more interest rate risk in Year 6 with the second ARM. And interest rate risk can cost you money on your mortgage.
If you want to find out if an ARM would save you money, call Amerifund at (888) 650-7316 or fill out this form and someone will contact you.
(c) Copyright Eris Saari 2016, 2019.