What is a Variable Rate Mortgage?
When you’re buying a new home, unless you’re paying cash, selecting the right type of mortgage is a critical step. Different mortgages are available to suit different people. The choice you make depends on your individual situation, so you need to know as much as you can about what’s available, including variable rate mortgages.
How Does a Variable Rate Mortgage Work?
In general, there are two different types of mortgage loans, fixed-rate and variable rate mortgages. A fixed-rate loan has one interest rate that stays the same for the length of the loan. A variable rate mortgage starts with one interest rate that fluctuates throughout the length of the loan. The most common variable rate mortgage is the Adjustable-Rate Mortgage, or ARM. One thing all adjustable-rate mortgages have in common is that the term, or length of the loan, is 30 years.
The best way to understand an ARM loan is to start by defining the terms you’ll see during your research.
Initial Interest Rate
Your lender will quote an initial interest rate. Typically, that rate will be slightly lower than a conventional fixed-rate mortgage.
Fixed-Rate Period/ Frequency of Change
When you apply for a variable rate mortgage, your lender will quote an initial interest rate that stays the same for a specific amount of time. That’s called a fixed-rate period. ARMs typically offer a fixed rate for 3, 5, 7, or 10 years.
Each ARM will also disclose how often the rate can change after the fixed-rate period ends. Most ARMs adjust interest rates every year.
These two definitions are displayed in a shorthand that consists of the fixed-rate period followed by the frequency of change. For example, a 3/1 ARM has a three year fixed-rate period, and it adjusts every year. If you see an ARM that adjusts interest rates every two years, it would be shown as a 3/2 ARM.
Margin Percentage
The lender will assign a margin percentage to an ARM. When the rates adjust, the lender will add the margin to the new rate that is based on the market at the time. ARMs have no limit on how far the interest rate can fall, but an ARM will never adjust to below the margin percentage.
Interest Rate Caps
The Initial Cap shows how much the interest rate can change the first time it changes after the fixed-rate period.
The Periodic Cap shows how much the interest rate can change from one adjustment to another after the first adjustment. In some ARMs, the initial cap and the periodic cap are the same, in others, that cap will be different.
A Lifetime Cap defines how much your interest rate can go up or down over the life of the loan.
The three caps are shown in a shorthand, also. If you see a rate cap of 2/2/5, that means that your interest rate can only change by 2 points at its first adjustment, and 2 points at every other adjustment. The last number indicates that the interest rate can only go up or down by 5 points over the life of the loan. If an ARM’s initial and periodic cap rate are the same, the shorthand would be 2/5.
ARM Adjustment Examples
A few examples will help to clarify the adjustments that an ARM can make. Let’s say you have a 5/1 ARM with a cap rate of 2/5, and your initial interest rate is 4%.
· After five years, assume that the interest rates rise to 7%. Your first interest rate adjustment would take your interest to 6% because of the 2 point initial and periodic cap.
· The next year, assume that interest rates again rise, and they’re at 10%. Your adjustment would take your interest to 9% because the ARM can only go up 5 points over its term.
· The next year, assume that interest rates fell to 6%. Your interest rate would go to 7% because the ARM can only change 2 points at every adjustment.
ARM Pros and Cons
The biggest advantage of an ARM loan is that you’ll get a lower initial interest rate than a conventional mortgage. That would also mean that your monthly payment is lower, and you may be able to pay more toward your principal every month. Another advantage is that your interest rate could be lower after periodic adjustments.
However, there are also disadvantages to an ARM. If rates rise, so will your interest rate and your monthly payment. If interest rates fluctuate significantly over an extended period of time, you could end up redoing your financial plan every year.
Another downside is that you don’t know what your financial situation will be if your interest rate does go up. If you’ve suffered a job loss, for example, the increase in your monthly payment could be a burden. Not many people can manage wild swings in their monthly commitments.
Also, ARMs can sometimes get you into a negative amortization situation. Let’s assume that your loan caps put you into a situation where your monthly mortgage payments don’t cover the monthly interest payment. The lender will take that shortage and add it to the amount of your principal payment. As a result, the amount that you owe will continue to increase, even though you’re making payments. And, to make matters worse, you’ll be charged interest on your interest shortages!
If you’re considering an ARM, make sure to read all the fine print and talk to your lender about whether a negative amortization problem could arise. And, as with any loan, ask if there is a prepayment penalty. If you get into a situation where you want to refinance or you sell your home, you don’t want to pay fees to do so. Some lenders also offer ARMS that you can convert to a fixed-rate loan.
Who Should Use an ARM Loan?
Typically, ARMs aren’t the best choice for someone who isn’t an experienced investor. With an ARM, you’ll need to be comfortable with the formulas that control your interest rate over the life of the loan, and be willing to put the effort into responding to changes in your mortgage payment as they happen. It’s helpful to ask yourself a few questions about whether to choose an ARM loan.
1. How long do you plan to stay in the home? With an ARM, you get a low fixed-rate interest loan for anywhere from three to seven years. If you plan to move before that fixed-rate period ends, and there are no prepayment penalties, an ARM could be perfect. Just keep in mind that plans do change.
2. Are you comfortable with the terms of your ARM? You’ll naturally want to talk to a number of lenders since the terms of an ARM vary. And, you need to be sure to ask the lender about all the various terms of the loan, including the margin and cap rates. Ask about negative amortization, and ask your lender to calculate what the monthly payment would be if interest rates shot up. If you’re not comfortable with that top-end payment, maybe the ARM isn’t for you.
3. What are interest rates doing? Do some research on the projections for interest rates in coming years. When rates are trending down, ARMs are popular. But, you also need to be realistic about interest rates. The U.S. economy has a big impact on interest rates, and the economy is pretty difficult to predict over a 30 year span.
Whenever you’re buying a home, it’s a good idea to have a professional local real estate agent and the right lender to help. In fact, often your local real estate agent will be able to give you referrals to a lender that can meet your needs. LemonBrew can match you with local agents, and you’ll even get a rebate on commission when you close! Head to our website to get the details.