The U.S. has always been the world capital of consumer choice. Visitors are often overwhelmed by the variety offered in our stores, supermarkets, and service industries. And the mortgage game is no different.
When making a major purchase like a home or RV, Americans have many different borrowing options at their fingertips, such as a fixed-rate mortgage or an adjustable-rate mortgage.
Almost everywhere else in the world, homebuyers have only one real option, the ARM (which they call a variable-rate mortgage).
An ARM is a loan with an interest rate that is adjusted periodically to reflect the ever-changing market conditions.
Usually, the introductory rate lasts a set period of time and adjusts every year afterward until the loan is paid off. An ARM lasts a total of thirty years, and after the set introductory period, your interest cost and your monthly payment will change.
Of course, no one knows the future, but a fixed can help you prepare for it, no matter how the tides turn. If you use an ARM it is harder to predict what your payments will be.
You can predict a rough range of how much your monthly payments will go up or down based on two factors, the index and the margin. While the margin remains the same for the duration of the loan, the index value varies. An index is a frame of reference interest rate published regularly. It includes indexes like U.S. Treasury T-Bills, the 11th District Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR).
Every potential homebuyer faces this decision, and there are pros and cons to both kinds of mortgages. What you plan to do both in the near and distant future determines which loan arrangement will be best for you.
The APR of a fixed-rate mortgage (FRM) remains the same for the life of the loan, and most homeowners like the security of "locking in" a set rate and the ease of a payment schedule that never changes. However, if rates drop dramatically, an FRM would need to be re-financed to take advantage of the shift, and that isn't easy at all.
An ARM is more of a roller coaster ride that you put your whole house on. It fluctuates with the real estate market and with the economy in general. The sweet five percent deal you have today could shoot up to eight percent if LIBOR goes up.
The reset point is the date your ARM changes from the introductory rate to the adjustable-rate based on market conditions. Many consumers wrongly believe this honeymoon period of having a preset low monthly payment needs to be as short as it is sweet.
But nowadays, it is not uncommon to set mortgage reset points years down the road. Reset points are typically set between one and five years ahead. Here are examples of the most popular mortgage reset points:
ARMs are typically tied to one of the following 3 indexes:
Adjustable-rate mortgages are not for everyone, but they can look very attractive to people who are either planning to move out of the house in a few years or those who are counting on a significant raise in income in the near future.
Basically, if your reset point is seven years away and you plan to move out of the house before then, you can manage to get out of Dodge before the costlier payment schedule kicks in.
Others who will benefit greatly from the flexibility of an ARM are people who expect a sizeable raise, promotion, or expansion in their careers. They can afford to buy a bigger house right now, and they will have more money to work with in the future when the reset date arrives. When the reset happens if rates haven't moved up they can refinance into a FRM.
ARMs are bad for worrywarts. If life's little uncertainties make you feel queasy, you may worry about the future of interest rates every waking moment. But don't worry - you won't end up losing the farm (or your signed Don Drysdale baseball card) because ARMs have caps on them.
A cap is a ceiling, or a limit on the amount your loan rate can increase annually for the duration of the loan. Adjustable-rate mortgage caps are usually set between two and five percent, and they carry a maximum yearly increase of two percent.
That is not exactly risky proposition, but it can appear so to a non-gambler.
You can run the numbers in advance to estimate the monthly cost at different APRs. Our above calculator does this automatically based on the cap you enter.
ARMs are not for the faint-hearted. They offer a better life to those who want lower payments now in exchange for spending more down the road. But make no mistake, your monthly payments will likely increase when your rate is adjusted.
You must be prepared financially for the end of the honeymoon. Because caps often don't apply to the one-time initial adjustment, you could see a worst-case scenario of your six percent rate adjusting to ten or twelve percent a year if interest rates in the overall economy shoot up.