If you bought a home with an adjustable rate mortgage (ARM) thinking you’d sell the home before the ARM adjusted, you’re not alone. Many people buy homes with ARMs because they plan to relocate or upgrade to a larger home in the near- to medium-term.
But when plans change and you decide to stay, you must know what will happen to your ARM – and what you can do about it. Let’s take a look.
ARM vs. fixed rates
ARMs help your budget because rates on ARMs are lower than they are for fixed loans. For example, today’s rates for a loan on a $300,000 home purchase with 20 percent down are 2.75 percent for a 5/1 ARM versus 3.5 percent for a 30-year fixed. In this scenario, the monthly 5/1 ARM payment ($980) is $98 cheaper than the 30-year fixed payment ($1,078).
This ARM vs. fixed savings is significant no matter what your home purchase price is, and if you are in fact only keeping the home (or the loan) short term, it can be worth it.
How to choose
The best way to determine whether you go with an ARM or a fixed loan is to peg your loan term as closely as you can to your expected time horizon in the home or the loan. Here are a few options to consider:
- If you’re buying a home with plans to relocate and sell the home within five years, a 5/1 ARM would be a good option. If you’re planning to move within 10 years, a 10/1 ARM would be a good option. You can also get 3/1 and 7/1 ARMs.
- If you plan to pay the loan off within five years and keep the home, a 5/1 ARM would also be a good option.
- If you’re going to relocate but want to keep the home, a fixed loan would be a good option.
How your ARM will adjust
If you get an ARM and plans change so that you need to keep the home (or the loan) longer than you intended, your payment will adjust at the end of the ARM’s fixed period.
An ARM is a 30-year loan with a rate that’s fixed for the initial period of the ARM. For example, the quoted rate on a 5/1 ARM will be fixed for that initial five-year period. For the remaining 25 years, it will adjust to a base rate (called a margin) plus the current level of a certain index the loan is tied to.
A common margin for a 5/1 ARM on a conforming loan up to $417,000 is 2.25 percent, and a common index for these loans is the one-year LIBOR which is 1.25 percent as of this week.
If your 5/1 ARM adjusted today, it would adjust to a rate of 3.5 percent, which is the 2.25-percent margin plus the 1.25-percent LIBOR index level as of now, and it will adjust once per year every year after the initial five-year fixed period. The margin will always be 2.25 percent, but the LIBOR index changes in real time, and will be higher if economic conditions improve, or lower if economic conditions worsen in the future.
And finally, it’s not just the rate that adjusts, it’s also your payment. In the initial five-year period, the payment is calculated using the initial rate and a 30-year amortization. After the initial period, the payment is calculated using the margin plus index rate and a 25-year amortization.
Using our scenario above, this means your payment would adjust from $980 to $1,063.
What to do if your ARM is almost out of time
You could argue that a payment adjustment like this would be tolerable if you were keeping the home (or the loan), but this example is only the first adjustment, and it will adjust every year after the initial adjustment, so it’s a lot of risk to take on.
The alternative is to refinance into a new loan, and the same rule would apply for deciding what loan to refinance into: do your best to peg the new loan term to your expected time horizon in the home (or loan) from this point forward.
Rates have been steadily low for the past five years as the economy has been slowly recovering from the economic crisis. If this recovery and economic growth continues, rates have more risk of rising.
As such, if you chose a new 5/1 ARM today, it would be safest to assume that your rate and payment would adjust up in another five years. If this is too much risk for you, the best choice is to take a slightly higher rate and payment now on a 30-year fixed, which gives you the security of knowing your rate and payment cannot change.
Other important facts about ARMs
Keep in mind that the payments above don’t include homeowners insurance and property taxes, which would be the same whether you chose an ARM or a fixed loan. You can run your own fixed vs. ARM scenarios , and the results will show you homeowners insurance and property taxes.
Another point to remember is that ARMs shouldn’t be used to qualify for more home than you can afford. This was a common scenario prior to the economic crisis, when lenders were allowed to qualify borrowers using the lower ARM payment. Now lenders must use the highest-case payment that could occur after the adjustment.
As a final note, if your loan amount is up to $417,000, a 5/1 ARM will get you the best savings relative to a 30-year fixed. If you have a jumbo loan above $417,000, you can also get strong savings using a 7/1 ARM relative to a 30-year fixed, so ask your lender to provide both options.
- What is an Adjustable Rate Mortgage or ARM Loan?
- Confessions of a Serial Refinancer
- How Mortgage Strategy Differs for Millennials, Gen Xers, and Baby Boomers