An adjustable-rate mortgage, or ARM for short, is attractive to homeowners because the introductory interest rate is often lower than rates on traditional fixed-rate loans. That translates into lower monthly payments. ARMs can make sense if you plan to sell your home or refinance your mortgage before the introductory rate expires.
Just keep in mind that there's no guarantee you can sell or refinance in time, especially if real estate markets are depressed or the lending environment is tight. If you're a current homeowner with an ARM, look into your loan options long before the rate resets. A day spent investigating alternatives could save you thousands.
Get to know your ARM
Review your ARM's original paperwork to familiarize yourself with the conditions of the loan. Focus on these four areas as you go through the documents.
Index: Lenders use a widely followed index as the basis for the interest rate you pay on an ARM. A common index is the London Interbank Offered Rate, or LIBOR, the rate major world banks charge each other for loans.
Margin: This is the percentage you pay above or (rarely) below an index. "LIBOR plus 2," for example, means you'll pay an interest rate two percentage points above LIBOR. If LIBOR is 4% and your margin is 2%, then your mortgage rate is 6%.
Interest Rate Cap: This limits the amount your rate can increase in a given timeframe. Periodic caps govern how much your rate can increase from one period to the next, such as from year to year. Lifetime caps set the maximum amount the rate can rise above the introductory rate during the loan's duration.
Adjustment Period: This is how frequently your rate changes.
Once you understand the terms of your ARM, think about how long you plan to live in your home. If it's less than five years, then you may benefit from refinancing into another ARM. If you hope to stay in your house for the long haul, a fixed-rate mortgage may be a better deal for you.
Evaluate your refinancing options
Now it's time to consider what actions to take before your ARM resets to a higher interest rate. Start by determining your monthly payment once your introductory rate expires. An online ARM calculator can help. If you can handle the new payment, then your job is done. But if it's more than you can afford, explore alternatives.
A common tactic is to refinance into a loan with a lower monthly payment. Look into 15- or 30-year fixed-rate mortgages, since the payments will be steady and predictable. Also explore a new ARM, such as a 5/1 ARM, which can also have a 30-year term but offers a low fixed rate for five years before resetting in the sixth year. Use this worksheet to keep track of loan terms and compare mortgages, both adjustable and fixed, to each other.
Let's say you need to refinance a $200,000 loan for 30 years. According to the U.S. Federal Reserve, a 30-year fixed-rate mortgage at 6% interest will cost you $1,199 a month. If you refinance into a 5/1 ARM with an introductory 4% rate, monthly payments for the first five years will be $955. Saving $244 a month--or about $14,640 over five years--sounds hard to beat, right?
The problem is, the monthly ARM payment can increase starting in the sixth year. Assuming the periodic rate cap is 2%, the rate may rise to as high as 6% in Year 6. At that point, your payment would go up to $1,166, which is still $33 less than the 30-year fixed. In Year 7, though, you could get hit with another 2% rate increase. That would bump your payment up to $1,390, or $191 more than the fixed-rate amount.
It can get worse if you're living in a rising-interest-rate environment. If the lifetime cap on your loan is 8%, your rate could eventually be as high as 12%--the introductory 4% plus 8%--yielding a monthly payment as high as $1,865. That's nearly double the introductory payment. Suddenly, that $1,199 payment on a 30-year fixed looks pretty good if you're planning to own your home for a long time. If you plan to sell within five years, the ARM is a better choice.
Face the realities of refinancing
Refinancing an ARM isn't free, so take into consideration closing costs and breakeven points. You might save $200 a month with a refinance, but if the upfront costs are, say, 5% ($10,000 on a $200,000 loan), you wouldn't break even for a full 50 months. The Federal Reserve says typical closing costs on a refinance range between 3% and 6%. Also make sure there's no prepayment penalty on your ARM, or you might find yourself eating that cost as well.
As you evaluate your options, be realistic about the future. Is your job secure? Will late payments or too much debt hurt your credit score? Could lending markets turn so tough that even borrowers with outstanding credit can't get loans? These scenarios might prevent refinancing indefinitely.
Take safeguards just in case you find yourself on the losing end of an ARM gamble. Start by setting aside a portion of the money you're saving on an ARM during the introductory period. That way, if the ARM resets before you can refinance, you can use the savings to pay down your principal. That should lower your monthly payment, even with a higher interest rate. When needed, cut expenses or generate extra income to eat away at your loan balance.
Accept the fact that you may have to sell your property. Use the proceeds to purchase a less expensive home, or rent until you're in a better financial position. If you absolutely can't meet your monthly payments, and you can't sell, then talk to your lender about a loan modification.