Adjustable Rate Mortgages
The DC market is more buyer friendly in 2024, but interest rates pose a barrier. Is an adjustable rate mortgage the answer? While high rates linger, an option that starts low and can be refinanced might be just the edge buyers need right now
What Is An Adjustable Rate Mortgage?
An adjustable-rate mortgage–ARM or ‘variable rate mortgage’–is a mortgage loan with an interest rate that adjusts with the market. Often with an initial rate lower than a conventional, fixed-rate mortgage loan, ARMs fluctuate with market rates, so if interest rates go down, an ARM rate can lower, but if rates go up, so does your rate.
There are a variety of ARM types; 3/1, 5/1, 7/1, 10/1, 5/6, and so on, each with a fixed and adjustable period:
- Fixed: The first 3, 5, 7 or 10 years of the loan, during which your interest rate won’t change;
- Adjustable: The remaining years of the loan, when your interest rate can go up or down based on changes in the benchmark rate (an interest rate which serves as the standard by which other interest rates are assessed).
The benchmark rate represents the lowest interest rate, fluctuating with a wide variety of pressures. Two key benchmarks are:
- The federal funds rate set by the Federal Reserve;
- The prime rate, which is set by banks.
The Fed’s benchmark rate influences other benchmark rates throughout the economy, such as the prime rate set by banks.
The ARM index is often a benchmark rate such as the prime rate, but it can also be based on LIBOR, Secured Overnight Financing Rate (SOFR), or the rate on short-term U.S. Treasuries. With a couple of possible exceptions, the rate on the ARM after the initial rate period ends equals the most recent value of a specified interest rate index, plus a margin. The index plus margin is the “fully indexed rate.” The index rate can change, but the margin stays the same. Example: If the index is 5% and the margin 2%, the interest rate on the mortgage adjusts to 7%. If the index is at only 2% the next time that the interest rate adjusts, the rate falls to 4% based on the loan’s 2% margin.
The second digit in the ARM type (3/1, 5/1, 7/1, 10/1, 5/6) refers to the frequency of the rate adjustment after the fixed period. A 5/1 ARM adjusts once a year. A 5/6 ARM, the rate adjusts every 6 months. A 30-year ARM with a 5-year fixed period would have a low, fixed rate for the first 5 years of the loan adjust with the market the remaining 25 years.
There are conforming and non-conforming ARMs, just as there are for conventional mortgages:
- Conforming lARMs meet Freddie Mac and Fannie Mae underwriting guidelines;
- Non-conforming ARMs do not.
Non-conforming loans carry their own set of risks and it is important to carefully assess the loan terms and lender before committing to a non-conforming loan.
Two of the most common non-conforming mortgage loans are jumbo loans, FHA, VA and USDA. These loans, except the jumbo, are guaranteed by the government.
Bullet Points
- Ask about rate caps
- Research ARM types
- Learn about qualifying
- Learn about refinancing ARMs
Michael V
I went to The Isaacs Team after working with another realtor that wasn’t really delivering the level of detail on potential homes that I was seeking. Susan and Alex not only met, but exceeded my expectations in the level of knowledge I sought. Their level of professionalism has secured them a client in me, for all future property purchases.
Annual Rate Caps For ARMS
ARMs may carry rate caps, which restrict interest rate increases over the life of the loan. Typically 5%, this cap means the rate can never be five percentage points higher than the initial rate. The cap can vary by lender, so this is an important factor to evaluate with each ARM loan program.
An annual ARM cap is a clause limiting increase in the loan’s interest rate during each year. The cap, or limit, is usually defined in terms of rate, but dollar amount of the principal and interest payment may be capped as well.
Annual caps protect borrowers against sudden and excessive increases in monthly payments when rates rise sharply over a short period of time, such as we’ve experienced in 2022.
There are actually three kinds of caps:
Initial adjustment cap. This cap says how much the interest rate can increase the first time it adjusts after the fixed-rate period expires. It’s common for this cap to be either two or five percent – meaning that at the first rate change, the new rate can’t be more than two (or five) percentage points higher than the initial rate during the fixed-rate period.
Subsequent adjustment cap. This cap says how much the interest rate can increase in the adjustment periods that follow. This cap is most commonly two percent, meaning that the new rate can’t be more than two percentage points higher than the previous rate.
Lifetime adjustment cap. This cap says how much the interest rate can increase in total, over the life of the loan. This cap is most commonly five percent, meaning that the rate can never be five percentage points higher than the initial rate. However, some lenders may have a higher cap.
The CFPB says:
Compare rate caps when comparing ARMs. Two different lenders may have the same initial interest rate but offer different rate caps. Even if you think you’ll move or refinance before the adjustable period starts, it’s a good idea to know how much your rate can change.
Types Of ARMS
Which one is right for you?
There are a variety of ARMs offered, primarily Hybrid, interest-only, and payment option.
The Hybrid
Offers a combination of fixed and adjustable rate periods. The interest rate is fixed initially, then adjusts at a specified time, such as one year, as we outlined above.
Interest Only
With an ‘IO’ borrowers pay only the interest on the mortgage for a specific time frame, then both interest and the principal on the loan. The longer the I-O period, the higher your payments will be when it ends. We classify this as an ‘expert only’ loan. Only those with sufficient acumen should consider it, under very specific circumstances.
Payment Option
A payment-option ARM offers borrowers the ability to make payments covering principal and interest, paying down just the interest, or paying a minimum amount that does not even cover the interest. Also dangerous because the lender must be paid in full by the date specified in the contract and interest charges are higher when the principal isn’t being paid down. Not recommended except for the most disciplined, informed borrower, and then only in certain circumstances.
Pro Tips
Things to consider before making any decisions about purchasing with an adjustable rate mortgage
Here is a booklet authored by the CFPB (Consumer Finance Protection Bureau) explaining adjustable rate mortgages. Read this before contacting a lender so you’ll know what questions to ask about ARM programs offered in the Washington DC area.
The CFPB recommends borrowers Ask the lender to calculate the highest payment you may ever have to pay on the loan you’re considering. You can also find this information on your Truth-in-Lending disclosure, which lenders are required to provide you within three business days after you apply for a loan, (but by this time you’ve committed to a property and paid an Earnest Money Deposit and a loan application fee. Best to get this information up front).
Qualifying For ARMS
Contact several lenders to get program requirements for each ARM type you’re considering. In general:
- Minimum 3.5% – 5% down payment.
- Minimum qualifying FICO® Score of 580 – 620
- Debt-to-income ratio (DTI) of no more than 50%.
- Maximum loan-to-value ratio (LTV) of 95%.
Refinancing ARMS
You can refinance your adjustable-rate mortgage into a fixed-rate mortgage when it comes time for your rate adjustment, even into another ARM, but know that there are fees and closing costs associated with any refinance. Fees are particular to the new loan program you choose, and closing costs can be anywhere between 2% – 6% of the loan amount, although they tend to be lower on a refinance. Here’s a Rocket Mortgage explainer
ARM Pros and Cons
Pros
For some borrowers, an ARM can be the solution to a market issue.
- The initial rate is usually lower than a fixed-rate mortgage, making monthly payments more affordable and qualification for a higher loan amount possible
- Caps limit how much your interest rate and payment can rise over the life of the ARM loan
- Pay off the loan in full, refinance, or sell your home, before the adjustment period kicks in if it is disadvantageous
- Build reserves to offset higher rates when they come if you stay in the home post-fixed period. A catastrophic life event such as job loss, serious illness or severe market conditions can impact your ability to meet the payment of any mortgage loan, or for that matter, rent (which also rises). Having reserves eases the stress
- You can match the initial fixed-rate period to length of time you plan to own your home if it is not long term
Payment may adjust down if interest rates fall.
Cons
As with any type of loan or financial investment, risks apply.
- Payments Increase If interest rates rise, your payments will also rise after the adjustable period begins
- Unplanned Events Planning for future financial events can be iffy. Even careful planning can fail to take into account unexpected events such as a job loss, serious prolonged illness. or severe market events. If you’re unable to sell or refinance, you’ll have the added stress of making higher payments or going into default. This is the reason having minimum 3-6 months of reserves for rate increases is important
- It’s not simple ARMS are more complicated than a standard conventional mortgage loan, where you know what payment to expect throughout the life of the loan. Make certain you understand the rules, fees and terms of the loan
- Rate difference may not be worth it As Rocket Mortgage explains, “as interest rates go down, there tends to be a narrowing of the yield curve. This gets a little bit technical, but basically the yield curve deals with the difference between fixed- and adjustable-rate mortgages. If you’re saving a significant amount on the front end of the loan by going with an ARM, it can be worth it. If the difference is 10 basis points (10 hundredths of a percentage point), not so much.”
Checklist
Determine which type of variable rate mortgage is right for your circumstances, if at all.
- Check the rate, fixed & adjustable periods
- Check the cap
- Check the loan cost
- Calculate the highest possible payment and determine if this ‘worst case scenario’ is acceptable to you
- Remind yourself that personal, local, national and global economic factors can impact your ability to pay your mortgage
- Build minimum 3-6 months of mortgage payment reserves to help offset rate increases
- Never enter into a mortgage loan of any type that you don’t understand fully, or aren’t certain you’re financially capable of fulfilling.
Now go forth and conquer the market! Be sure to call us first. We’ll walk you through the process like you’re a member of the family!
Disclaimer
Information provided on this page is posted for educational purposes only. It is not to be construed as legal, tax or financial planning advice. Always consult a mortgage professional when considering a refinance. Citations are not intended as endorsements.
Ready to make a new investment in yourself?
