Mortgages , Personal Loans

How Does An Arm Loan Work

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 9 minute read

Trying to shop for a mortgage can make you feel like you need to learn a whole new language. It’s a lot to take in, what with loan-to-value ratios and front- and back-end debt-to-interest ratios, cash on hand, and credit-scoring formulas.

How do you answer when the loan officer asks if you want a fixed-interest loan or an adjustable-rate mortgage? What follows is a complete guide to ARMs, or adjustable rate mortgages.

What Is a Mortgage with Adjustable Rates (ARM)?

A mortgage with an interest rate that fluctuates over time is known as an adjustable-rate mortgage. You can compare this to fixed-interest mortgages, where the interest rate doesn’t change during the course of the loan’s 15-30 year term.

What Drives ARM Interest Rates

Interest rates on ARMs fluctuate based on changes in the benchmark index and the margin. The interest rate of an adjustable-rate mortgage (ARM) is determined by a mortgage lender in relation to a specific index. The Fed Funds Rate and the LIBOR are two often used references (London Interbank Offered Rate). 

Both of these interest rates are market benchmarks that financial institutions commonly use when making loans to one another.

Unfortunately, you no longer have the same level of creditworthiness as a bank, and lenders require a return on their investment. They add a margin to the already low index rate. Allow us to use an ARM with a 4% margin over LIBOR as an example. The interest rate would be 4.5 percent if the LIBOR was 0.5 percent.

In contrast to credit cards, the interest rate on your loan does not roll over every month. While certain adjustable rate mortgages (ARMs) reset less frequently than annually, this is not the case for most.

Fixed-Rate Periods

When you take out an ARM loan for the first time, the interest rate is usually fixed for a set period of time. For the first three to seven years of the loan, the interest rate is set artificially low by the lender as an enticement to the borrower. Historically, interest rates have increased sharply after they begin to adjust following a rate change.

Lenders benefit from either outcome since they get to keep more of your money whether or not you refinance your mortgage to a lower interest rate. When you take out a new loan, including a refinance, the lender makes money through origination fees. 

In addition, they make more money at the beginning of the loan because a larger share of your monthly payment goes toward interest rather than reducing your balance.

Lenders also favor ARMs over fixed-interest loans because their interest earnings are more stable and more closely tied to market fluctuations. As the rate of interest rises, they can increase their prices. It’s not like they have to pay you back for the cheap interest rate you got when you first got the loan.

The interest rate and the number of years the loan is amortized over are the only constants in an adjustable-rate mortgage (ARM), the type of loan your loan officer will likely offer you. 

The first number represents the length of the fixed-rate term in years, while the second denotes the frequency with which the interest rate will be reset after that. Five years of a fixed interest rate are included in a 5/1 ARM, and then the rate changes once yearly.

Interest Rate Caps

The interest rate on most adjustable-rate mortgages is capped at a certain percentage point over the initial interest rate. If interest rates were to ever soar, increasing your mortgage payment would be financially disastrous.

The interest rate on an adjustable-rate mortgage (ARM) typically cannot increase by more than five percentage points from its initial introduction level, as stipulated by the lender. If you made an initial fixed payment of 4%, your maximum interest rate would be 9%. 

Your interest rate will remain the same regardless of what happens to the benchmark index or the margin on your loan.

Fixed-Rate Mortgage vs. ARM

All interest payments on a fixed-rate loan are made at the same rate over its full term. It makes little difference what happens to key interest rates in the years and decades to come. The interest rate will not change until the loan has been paid in full.

Lenders favor issuing ARMs because they hedge their bets against any future increases in interest rates. Accordingly, adjustable-rate mortgages (ARMs) are offered by most lenders at a lower beginning interest rate than fixed-rate mortgages.

Even though variable-rate loans may seem more attractive in this era of historically low rates, fixed-rate loans are typically the better option. There are a few notable exceptions, such as if you intend to move before the original fixed-rate period finishes or if your credit is so poor that you can only qualify for a very high fixed interest rate. 

Those with less-than-perfect credit should initially choose an adjustable-rate mortgage (ARM), spend the next five years bringing their credit score up, and then consider refinancing into a fixed-rate loan at a reduced interest rate.

Kinds of ARMs

APR loans can function in a variety of different ways. Before committing to an ARM, be sure you fully grasp the nuances of the different types.

Hybrid ARM

As was discussed above, the initial interest rate on a hybrid ARM is fixed. These days, ARMs of all types are hybrids. Remember that the initial low fixed interest rate is offered by lenders as an incentive since they prefer ARMs.

Interest-Only ARM

All you have to pay back with an interest-only loan is the interest. In lieu of making payments toward the loan’s main sum, you’ve decided to make interest payments only. At the end of the loan period, you are responsible for repaying the whole principal balance.

To give you an example, I made an interest-only loan of $25,000 to a couple who were active in the real estate investment market at a 10% interest rate. The interest payment I receive from them is $2,500 per year or 10% of the principal. They promised to reimburse me the original $25,000 I lent them whenever they were ready to repay me in full.

Interest-only adjustable-rate mortgages function in the same way, but the interest rate changes. While your interest rate may be 5% this year, it could increase if the rate used as a benchmark increase.

Getting a mortgage with just the interest paid is unusual. A percentage of the principal balance is typically repaid with each mortgage payment under an amortizing loan. By making regular principal payments, you can reduce the debt more quickly.

ARM With Payment Options

The amount you pay each month may be adjustable with some ARMs. 

These choices include:

  • You make a payment each month that covers the entire interest and principal balances.
  • As with a standard interest-only adjustable rate mortgage, you will only be responsible for making interest payments.
  • Payment is so little that it doesn’t even cover the interest accruing on the balance.
  • Similar to making the minimum payment on a credit card to avoid late fees but then incurring even more interest charges.

In other words, if you want to get deeper and deeper into debt, payment-option ARMs are the tool for the job. Although freedom would be appreciated during tough times, it would be simple to lose track of reality in favor of more interesting pursuits.

Making merely the minimum payment will result in additional interest charges being added to your balance. Imagine a situation in which your interest rate gradually increases instead of decreasing as time passes, which is similar to the effect of compounding done backward.

ARM for Negative Amortization

Although this mortgage kind is unusual today, it follows the same basic structure as the minimum payment method described above. You aren’t making any progress on the main balance and aren’t even making enough interest payments to cover the total amount of your debt.

Lenders provided adjustable-rate mortgages (ARMs) with negative initial amortization periods. The result was affordable payments for the first several months. The payments would then increase over time to ensure that the loan’s principal and interest are repaid in full.

These loans were first offered by financial institutions in the 1980s when interest rates were sky-high but it was widely believed that they would eventually fall. As an alternative to negative amortization ARMs, payment-option ARMs rose to prominence in the 1990s.

Is It Time to Refinance an ARM?

Many homeowners anticipate having to sell or refinance their property once their adjustable interest rate begins to rise. Although there are benefits, there are also many drawbacks to mortgage refinancing.

Lender fees, title fees, and other closing costs can easily run into hundreds of dollars. When you refinance, you have to pay closing costs, and your amortization schedule starts over. The majority of your monthly payment will be applied to interest, rather than principal. 

Most of your principal balance will be paid off in the final few years of the loan’s term because the percentage of each payment that goes toward interest decreases only gradually.

It is the lenders’ hope that you would never have to resort to such measures. They are interested in refinancing you indefinitely so that they can continue to collect closing expenses. 

They plan to continually reset your amortization schedule to the beginning. It’s a never-ending debt spiral where you’re constantly tempted to borrow more by the promise of easy access to the equity in your property.

If you intend to remain in the house for the foreseeable future, it is recommended that you obtain a loan with a fixed interest rate. Consider an adjustable-rate mortgage if you know you’ll be moving close to the conclusion of your fixed-rate loan’s term. However, if you don’t sell by then, your payments would likely increase.

Advantages of Adaptable-Rate Mortgages

Many borrowers look askance at ARM loans, yet there are situations in which they make sense. As you compare mortgages, keep in mind the following benefits of adjustable-rate loans (ARMs).

  1. Short-Term Low-Fixed-Interest Rate Commitment. Lenders entice borrowers with initially cheap fixed interest rates. During this time, the interest rate is typically lower than what you would pay with a traditional fixed-rate mortgage. ARMs can save you money if you plan to sell or refinance your house before the original period finishes.
  2. Rate Limits on Interests. Your mortgage’s interest rate and payment are capped by the lender no matter how high rates go.
  3. The Potential for Reduced Payments Exists. Your interest rate and payment could potentially decrease if interest rates were to fall between now and the conclusion of your fixed interest period, though this is highly unlikely.
  4. Credit Risk Takers Welcome. At the height of the housing boom in the early 2000s, adjustable-rate mortgages (ARMs) were widely viewed as a kind of subprime financing. Until the end of the fixed interest period, borrowers with poor credit were able to qualify for ARMs with manageable monthly payments. The question of whether or not people with poor credit should buy a home or continue renting is debatable, but adjustable-rate mortgages (ARMs) do offer a possible entry point into home ownership.

The Disadvantages of adjustable-rate mortgages

There are a lot of disadvantages to these adjustable-rate loans. Before purchasing a home with a mortgage, be sure you fully comprehend them.

  1. Better Compensation Likely. The margin is set by the lender so that the borrower’s interest rate will almost surely increase beyond the initial fixed period. You will likely pay a higher rate even if benchmark rates go down a little between now and when your rate starts adjusting because lenders price in a wide margin.
  2. The Possibility of Prepayment Penalties Exists. There may be a fee if you pay off your ARM early. Lenders sometimes impose this substantial cost for prepayment, usually between the first two and fifth years of the loan’s term. You may incur a penalty if you intend to use an adjustable-rate mortgage (ARM) for a short period of time, with the intention of paying it off before the interest rate adjusts. Make sure you know the terms of any loan you’re considering before agreeing to it.
  3. The danger of Maintaining the ARM. It’s not guaranteed that you’ll be able to sell or refinance the property before the interest rate adjusts. Keeping your expensive adjustable-rate mortgage (ARM) or refinancing might be your only choice if you ultimately decide to stay in the house. Additionally, if your credit score lowers, refinancing may prove more challenging or expensive than you anticipate.
  4. Complexity. When faced with such a substantial regular expense, no one enjoys adding financial complexity to their lives. Even the savviest borrower may be thrown off by the idiosyncratic rules and fees associated with an adjustable-rate mortgage. The entire notion of ARMs seems like an elaborate hoax. Lenders use enticingly low introductory rates with the expectation of pocketing much more in interest and/or refinancing costs once the introductory period ends.

Bottom Line

Mortgages with variable interest rates are another financing choice. However, they aren’t without their own dangers and drawbacks, especially for borrowers who aren’t very knowledgeable about money management.

It makes the most sense to think of ARMs as short-term mortgage loans, but even that assumption is dubious. It takes a long time to build up enough equity to cover the closing fees of buying a property and the second set of closing charges when you decide to sell. Consider renting instead of buying if you expect to live in a house for less than five years.

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