All About Adjustable-Rate Mortgages

Adjustable-rate mortgages (ARMs) differ from fixed-rate mortgages in that the interest rate and monthly payment can change over the life of the loan. ARMs also generally have lower introductory interest rates vs. fixed-rate mortgages. Before deciding on an ARM, key factors to consider include how long you plan to own the property, and how frequently your monthly payment may change.

Why choose an adjustable-rate mortgage?
The low initial interest rates offered by ARMs make them attractive during periods when interest rates are high, or when homeowners only plan to stay in their home for a relatively short period. Similarly, homebuyers may find it easier to qualify for an ARM than a traditional loan. However, ARMs are not for everyone. If you plan to stay in your home long-term or are hesitant about having loan payments that shift from year-to-year, then you may prefer the stability of a fixed-rate mortagage.

Components of adjustable-rate mortgages
Adjustable-rate mortgages have three primary components: an index, margin, and calculated interest rate.

  • Index
    The interest rate for an ARM is based on an index that measures the lender’s ability to borrow money. While the specific index used may vary depending on the lender, some common indexes include U.S. Treasury Bills and the Federal Housing Finance Board’s Contract Mortgage Rate. One thing all indexes have in common, however, is that they cannot be controlled by the lender.
     
  • Margin
    The margin (also called the “spread”) is a percentage added to the index in order to cover the lender’s administrative costs and profit. Though the index may rise and fall over time, the margin usually remains constant over the life of the loan.
     
  • Calculated interest rate
    By adding the index and margin together, you arrive at the calculated interest rate, which is the rate the homeowner pays. It is also the rate to which any future rate adjustments will apply (rather than the “teaser rate,” explained below).

Adjustment periods and teaser rates
Because the interest rate for an ARM may change due to economic conditions, a key feature to ask your lender about is the adjustment period–or how often your interest rate may change. Many ARMS have one-year adjustment periods, which means the interest rate and monthly payment is recalculated (based on the index) every year. Depending on the lender, longer adjustment periods are also available.

An ARM can also have an initial adjustment period based on a “teaser rate,” which is an artificially low introductory interest rate offered by a lender to attract homebuyers. Usually, teaser rates are good for 6 months or a year, at which point the loan reverts back to the calculated interest rate. Remember, too, that most lender will not use the teaser rate to qualify you for the loan, but instead use a 7.5% interest rate (or calculated interest rate if it is lower).

Rate caps
To protect homebuyers from dramatic rises in the interest rate, most ARMs have “caps” that govern how much the interest rate may rise between adjustment periods, as well as how much the rate may rise (or fall) over the life of the loan. For example, an ARM may be said to have a 2% periodic cap, and a 6% lifetime cap. This means that the rate can rise no more than 2% during an adjustment period, and no more than 6% over the life of the loan. The lifetime cap almost always applies to the calculated interest rate and not the introductory teaser rate.

Payment caps and negative amortization
Some ARMs also have payment caps. These differ from rate caps by placing a ceiling on how much your payment may rise during an adjustment period. While this may sound like a good thing, it can sometimes lead to real trouble.

For example, if the interest rate rises during an adjustment period, the additional interest due on the loan payment may exceed the amount allowed by the payment cap–leading to negative amortization. This means the balance due on the loan is actually growing, even though the homeowner is still making the minimum monthly payment. Many lenders limit the amount of negative amortization that may occur before the loan must be restructured, but it’s always wise to speak with your lender about payment caps and how negative amortization will be handled.

Understanding Different Types of Loans

Today’s homebuyer has more financing options than have ever been available before. From traditional mortgages to adjustable-rate and hybrid loans, there are financing packages designed to meet the needs of virtually anyone.

While the different choices may seem overwhelming at first, the overall goal is really quite simple: you want to find a loan that fits both your current financial situation and your future plans. Though this article discusses some of the more common loan types, you should spend time talking with different lenders before deciding on the right loan for your situation.

General categories of loans
Most loans fall into three major categories: fixed-rate, adjustable-rate, and hybrid loans that combine features of both.

  • Fixed-rate mortgages
    As the name implies, a fixed-rate mortgage carries the same interest rate for the life of the loan. Traditionally, fixed-rate mortgages have been the most popular choice among homeowners, because the fixed monthly payment is easy to plan and budget for, and can help protect against inflation. Fixed-rate mortgages are most common in 30-year and 15-year terms, but recently more lenders have begun offering 20-year and 40-year loans.
  • Adjustable-rate mortgages (ARM)
    Adjustable-rate mortgages differ from fixed-rate mortgages in that the interest rate and monthly payment can change over the life of the loan. This is because the interest rate for an ARM is tied to an index (such as Treasury Securities) that may rise or fall over time. In order to protect against dramatic increases in the rate, ARM loans usually have caps that limit the rate from rising above a certain amount between adjustments (i.e. no more than 2 percent a year), as well as a ceiling on how much the rate can go up during the life of the loan (i.e. no more than 6 percent). With these protections and low introductory rates, ARM loans have become the most widely accepted alternative to fixed-rate mortgages.
  • Hybrid loans
    Hybrid loans combine features of both fixed-rate and adjustable-rate mortgages. Typically, a hybrid loan may start with a fixed-rate for a certain length of time, and then later convert to an adjustable-rate mortgage. However, be sure to check with your lender and find out how much the rate may increase after the conversion, as some hybrid loans do not have interest rate caps for the first adjustment period.

Other hybrid loans may start with a fixed interest rate for several years, and then later change to another (usually higher) fixed interest rate for the remainder of the loan term. Lenders frequently charge a lower introductory interest rate for hybrid loans vs. a traditional fixed-rate mortgage, which makes hybrid loans attractive to homeowners who desire the stability of a fixed-rate, but only plan to stay in their properties for a short time.

Balloon payments
A balloon payment refers to a loan that has a large, final payment due at the end of the loan. For example, there are currently fixed-rate loans which allow homeowners to make payments based on a 30-year loan, even though the entire balance of the loan may be due (the balloon payment) after 7 years. As with some hybrid loans, balloon loans may be attractive to homeowners who do not plan to stay in their house more than a short period of time.

Time as a factor in your loan choice
As has been discussed, the length of time you plan to own a property may have a strong influence on the type of loan you choose. For example, if you plan to stay in a home for 10 years or longer, a traditional fixed-rate mortgage may be your best bet. But if you plan on owning a home for a very short period (5 years or less), then the low introductory rate of an adjustable-rate mortgage may make the most financial sense. In general, ARMs have the lowest introductory interest rates, followed by hybrid loans, and then traditional fixed-rate mortgages.

FHA and VA loans
U.S. government loan programs such as those of the Federal Housing Authority (FHA) and Department of Veterans Affairs (VA) are designed to promote home ownership for people who might not otherwise be able to qualify for a conventional loan. Both FHA and VA loans have lower qualifying ratios than conventional loans, and often require smaller or no down payments.

Bear in mind, however, that FHA and VA loans are not issued by the government; rather, the loans are made by private lenders. FHA loans are insured to the actual lender and VA loans are guaranteed in case the borrower defaults. Remember too, that while any U.S. citizen may apply for a FHA loan, VA loans are only available to veterans or their spouses and certain government employees.

Conventional loans
A conventional loan is simply a loan offered by a traditional private lender. They may be fixed-rate, adjustable, hybrid or other types. While conventional loans may be harder to qualify for than government-backed loans, they often require less paperwork and typically do not have a maximum allowable amount.

How Mortgage Loans Work

Excluding property taxes and insurance, a traditional fixed-rate mortgage payment consist of two parts: (1) interest on the loan and (2) payment towards the principal, or unpaid balance of the loan.

Many people are surprised to learn, however, that the amount you pay towards interest and principal varies dramatically over time. This is because mortgage loans work in such a way that the early payments are primarily in interest, and the later payments are primarily towards the principal.

In the beginning… you pay interest
To help calculate monthly payments for loans based on different interest rates, lenders long ago developed what are known as “amortization tables.” These tables also make it fairly easy to calculate how much money of each payment is interest, and how much goes towards the principal balance.

For example, let’s calculate the principle and interest for the very first monthly payment of a 30-year, $100,000 mortgage loan at 7.5 percent interest. According to the amortization tables, the monthly payment on this loan is fixed at $699.21.

The first step is to calculate the annual interest by multiplying $100,000 x .075 (7.5 %). This equals $7,500, which we then divide by 12 (for the number of months in a year), which equals $625.

If you subtract $625 from the monthly payment of $699.21, we see that:

  • $625 of the first payment is interest
  • $74.21 of the first payment goes towards the principal

Next, if we subtract $74.21 (the first principal payment) from the $100,000 of the loan, we come up with a new unpaid principal balance of $99,925.79. To determine the next month’s principal and interest payments, we just repeat the steps already described.

Thus, we now multiply the new principal balance (99,925.79) times the interest rate (7.5%) to get an annual interest payment of $7,494.43. Divided by 12, this equals $624.54. So during the second month’s payment:

  • $624.54 is interest
  • $74.67 goes towards the principal.

Note: In Canada, payments are compounded semi-annually instead of monthly.

Equity
As you can see from the above example, even though you pay a lot of interest up front, you’re also slowly paying down the overall debt. This is known as building equity. Thus, even if you sell a house before the loan is paid in full, you only have to pay off the unpaid principal balance–the difference between the sales price and the unpaid principle is your equity.

In order to build equity faster–as well as save money on interest payments–some homeowners choose loans with faster repayment schedules (such as a 15-year loan).

Time versus savings
To help illustrate how this works, consider our previous example of a $100,000 loan at 7.5 percent interest. The monthly payment is around $700, which over 30 years adds up to $252,000. In other words, over the life of the loan you would pay $152,000 just in interest.

With the aggressive repayment schedule of a 15-year loan, however, the monthly payment jumps to $927-for a total of $166,860 over the life of the loan. Obviously, the monthly payments are more than they would be for a 30-year mortgage, but over the life of the loan you would save more than $85,000 in interest.

Bear in mind that shorter term loans are not the right answer for everyone, so make sure to ask your lender or real estate agent about

When Should You Pay Points on a Loan?

When it comes to comparing interest rates for a mortgage loan, homebuyers often have the option of choosing a loan with a lower interest rate by paying points. Simply put, a point is equal to 1 percent of the loan amount. For example, with a $100,000 loan, one point equals $1,000. Points are usually paid out-of-pocket by the buyer at closing.

Paying points may seem attractive, because a lower interest rate means smaller monthly payments. But is paying points always a good idea? The answer generally depends on how long you plan to stay in the house. Let’s look at an example:

Bob and Betty Smith are shopping for loan rates on a $150,000 home. Their bank has offered them a 30 year loan at 7.5 percent with no points. This works out to a monthly payment of $1,049.

However, their bank has also offered them a loan at 7 percent if they agree to pay 2 points (or $3,000). At this lower rate, their monthly payment drops to $998, or a savings of $51 per month.

By dividing the amount they paid for the points ($3,000) by the monthly savings ($51), we see that they will have to own the house for 59 months (or just under 5 years) before they will start to see savings as a result of paying points. If Bob and Betty plan to stay in the house for many years, then paying points could make good sense. But if they see themselves moving to another house in the near future, they’d be better off paying the higher interest and no points. (Note: for simplicity, the above example does not take into account the time value of money, which would slightly lengthen the break-even time.)

Can you deduct points on your income taxes?
In the United States, one side benefit of paying points on a mortgage loan is that they are fully tax deductible for the same tax year as your closing. However, this does not apply to points paid for a refinance loan. For refinances, the IRS requires you to spread out the deduction over the life of the loan. For example, if you paid $5,000 in points for a 30-year refinance loan, you can only deduct 1/30 of the $5,000 each year for 30 years. If you pay off the loan early, though, you can deduct the remaining amount that tax year. As to this page and all pages regarding tax situations, please check with your tax professional.

15-Year, 30-Year, or a Biweekly Mortgage?

In the past, the 30-year, fixed-rate mortgage was the standard choice for most homebuyers. Today, however, lenders offer a wide array of loan types in varying lengths–including 15, 20, 30 and even 40-year mortgages.

Deciding what length is best for you should be based on several factors including: your purchasing power, your anticipated future income and how disciplined you want to be about paying off the mortgage.

What are the benefits of a shorter loan term?
Some homeowners choose fixed-rate loans that are less than 30 years in order to save money by paying less interest over the life of the loan. For example, a $100,000 loan at 8 percent interest comes with a monthly payment of around $734 (excluding taxes and homeowner’s insurance). Over 30 years, this adds up to $264,240. In other words, over the life of the loan you would pay a whopping $164,240 just in interest.

With a 15-year loan, however, the monthly payments on the same loan would be approximately $956–for a total of $172,080. The monthly payments are more than $200 more than they would be for a 30-year mortgage, but over the life of the loan you would save more than $92,000.

What are the advantages to a 30-year loan?
Despite the interest savings of a 15-year loan, they’re not for everyone. For one thing, the higher monthly payment might not allow some homeowners to qualify for a house they could otherwise afford with the lower payments of a 30-year mortgage. The lower monthly payment can also provide a greater sense of security in the event your future earning power might decrease.

Furthermore, with a little bit of financial discipline, there are a variety of methods that can help you pay off a 30-year loan faster with only a moderately higher monthly payment. One such choice is the biweekly mortgage payment plan, which is now offered by many lenders for both new and existing loans.

Biweekly mortgages
As the name implies, biweekly mortgage payments are made every two weeks instead of once a month–which over a year works out to the equivalent of making one extra monthly payment (compared to a traditional payment plan). One extra payment a year may not sound like much, but it can really add up over time. In fact, switching from a traditional payment plan to a biweekly mortgage can actually shorten the term of a 30-year loan by several years and save you thousands in interest.

If you’re interested in a biweekly payment plan, make sure to check with your lender. In many cases, lenders also offer direct payment services that automatically withdraw funds from your bank account, saving you the trouble of having to write and mail a check every two weeks.

Making extra payments yourself–do it early!
Another way to pay off your loan more quickly is to simply include extra funds with your monthly payment. Most lenders will allow you to make extra payments towards the principal balance of your loan without penalty. This is especially attractive to homebuyers who are concerned about their future earning power, but still want to be aggressive about paying off their loan.

For example, if you had a 30-year loan, you might decide to send the equivalent of one or two extra payments a year (which could shorten the overall length of the loan by many years). But if your financial situation suddenly took a turn for the worse, you could always fall back on the regular monthly payment.

One important note, though, is that if you do decide to send extra funds, make sure to do it EARLY in the life of the loan. This is because most home loans are calculated in such a way that the first few years of payments are almost entirely interest, while the last few years are mostly applied towards the principal balance. Thus, you can get the most bang for your buck by making the extra payments early in the life of the loan.