ARM interest rates, otherwise known as adjustable interest rates are rates that adjust at periodic and predetermined intervals. Many borrowers take the ARM loan because of its attractive introductory rate. These rates are often lower than fixed interest rates, providing an attractive alternative.
The reasons borrowers take the ARM loan varies. As we discussed above, some do it just to take advantage of the lower interest rate. Other borrowers do so to increase their purchase power. A lower interest rate means a lower payment. This reflects in the borrower’s debt ratio, giving them the potential to borrow more money.
Understanding ARM interest rates, how they adjust, and what affects them is crucial before you decide to take this type of mortgage.
How the ARM Loan Works
First, let’s look at how the ARM loan works. You can take several types of these loans, but the most common are the 3/1 and 5/1 ARM. The first number stands for the introductory period or fixed interest rate period. In the case of the 3/1, the rate would be fixed for the first three years and the 5/1 would be fixed for the first five years.
After that introductory period, these rates would change once per year on the annual adjustment date. You would know the date the rate would change. But you would not know how much the rate would change. It’s dependent on several factors including the index, margin, and designated caps.
The ARM Index
The ARM index is a fixed component of the ARM interest rates. You will know upfront which index your loan follows. Typically, banks use the one-year LIBOR index, but a few others include the Constant Maturities Treasury securities, and the Cost of Funds Index.
Once a lender quotes you an ARM rate with a corresponding index, that information usually remains the same throughout the closing procedures. If something were to change, the lender must let you know ahead of time. Knowing the index allows you to look back at the historical information of the index to see its patterns. While you can’t predict what it will do moving forward, knowing its patterns can be helpful.
The margin is a number the lender comes up with, but it remains the same throughout the life of the loan. The lender adds the margin to the ever-changing index to come up with your final rate during the adjustment period. The margin is the one predictable factor in ARM loans.
Understanding ARM Caps
As unpredictable as ARM interest rates are, there is some good news. Lenders do set certain caps on the rates. This helps to minimize the drastic changes an ARM rate can go through. You’ll see several different types of caps on your ARM loan:
- Initial adjustment cap – This is the most your rate can change during the 1st adjustment period. It only applies to this period and helps to minimize the drastic changes that can occur during that adjustment.
- Periodic cap – This is the most an interest rate can change during any adjustment period.
- Lifetime cap – This is the most the rate can change over the entire life of the loan. Once this cap is hit, the rate cannot increase anymore even if it’s in the middle of the term.
Your Personal Factors
In addition to the all of the above factors, your personal factors help determine your ARM interest rate. Just like a fixed rate loan, the lender must determine your risk level before they will quote you an interest rate. In other words, they want to determine what type of credit risk you are, which they determine from your credit score, total debts, and income.
You can minimize the interest rate by providing the lender with great factors. A high credit score, low debt ratio, and stable income will net you the lowest interest rate. You can further better your chances of getting a low interest rate by also making a large down payment. The lower your loan-to-value ratio, the lower the risk your lender takes.
ARM interest rates are generally lower than fixed rate loans, but they do come with some risks. Borrowers that plan to live in the home for a short time do the best with this loan type as does borrowers that have low income now but have good earnings potential down the road.
Before you take an ARM, discuss all of the implications of it with the lender. Make sure you ask about the worst-case scenario, in other words, how high the rate can get so you can plan for the worst. You do have the option to refinance out of an ARM whenever you want, though, which may help if the payment gets unaffordable.