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By G. Steven Bray
Adjustable rate mortgages, or ARMs, can be attractive because the initial interest rate can be significantly lower than a 30y rate. For example, today’s 5y ARM rate is about 1% lower than the 30y rate. On a $250k mortgage, that lowers the monthly payment by about $150.
ARMs have several characteristics that determine how their rate adjusts. At the end of the fixed term, in this case 5 years, the rate will adjust to an index rate plus a margin. A typical index is the 1y London Interbank Offering Rate, which today was 0.856%. Using a 2.25% margin, if our rate adjusted today, it would adjust to 3.125%.
The number one risk with ARMs is that the interest rate can go up over time. ARMs typically cap the amount the rate can increase each year and how much it can increase over the life of the loan. If our initial rate is 2.75%, and our caps are 2% and 5%, our rate could increase to 7.75% in the 8th year. That would raise the monthly payment by $663.
Given that, why, then, would you even consider an ARM? We’ll search for an answer next time.