“Be aware, do your research before you jump in,” said Linda McCoy, president of the National Association of Mortgage Brokers.
Here are questions and answers about adjustable rate mortgages:
What does it mean when an ARM is advertised as 5/1, 7/1 or 10/1?
The first number refers to the commitment period (five, seven or ten years). The second is the number of changes, which can change after the flat rate expires – in these examples, once a year. But loans with installments that change every six months are also common. They are typically given as 7/6 months, 10/6 months and so on.
Some loans allow a larger increase on the first reset — often five percentage points above the starting rate — and then allow increases of no more than two percentage points, said Sean Bloch, a Long Island mortgage broker. Some lenders underwrite ARMs based on the borrower’s ability to make payments at the initial fixed rate plus two percentage points, he said.
Most ARMs also set a cap on the total increase over the life of the loan. So if the initial fixed rate is 4 percent and the cap is 5, the interest rate can’t go higher than 9 percent — but that still results in a much larger monthly payment.
When does an ARM make sense?
If you’re certain you’ll be staying home for a relatively short period of time — less than the loan’s fixed-rate period — an ARM may make sense. You can sell the home or refinance the loan before the interest rate resets. People who can realistically expect a significant pay rise before the reset — such as medical professionals or law students — could also benefit, Ms McCoy said.
But the option may be too risky for hourly earners, for example, who see an adjustable-rate loan as the only way to afford a particular home. “I’m not going to give them an ARM,” she said. They could lose the home and much of their investment if they can’t make the higher payments.
Ultimately, it comes down to how comfortable you are with risk, said Dr. Seay from Kansas State University. “I have a low risk tolerance,” he said. “I would never have an ARM.”
Can interest on an ARM be reset to a lower interest rate?
Yes. After the initial redemption period, ARM rates are based on a benchmark market index and a fixed rate known as margin. So if the index falls, so can the lending rate. However, many loans have a floor below which the interest rate cannot fall. Ask your lender or check your disclosure documents to find out what that rate is.