A 10-Year ARM - A Long ARM
ARM mortgages are complicated, difficult to understand, and hard to compare. While all of that is true, an ARM can save you money.
In the mortgage market of 2012 with historically low interest rates most borrowers are locking into a FRM (Fixed Rate Mortgage). Purchasers tend to go for the longer 30-year loan, whereas many refinance borrowers are taking a 15-year FRM. However, many borrowers also consider or take an ARM (Adjustable Rate Mortgage).
ARMS, hybrid ARM, FRM, I/O, Balloon, 7/28 are just a few of the names for different mortgage products. The most common types of mortgage loans are 30-year FRM or 15-year FRM. Comparing mortgage loans is confusing because you have different lengths, payment schedules, interest rates and fees. A 10-year ARM is one type of adjustable rate mortgage, with a long period with a fixed interest rate.
In order to help you decide if this is an appropriate mortgage for your situation:
- Understand how an ARM works
- Compare Payment Schedules
- Evaluate the Pros/Cons – Does the ARM fit?
Understand How an ARM Works
An ARM offers a payment schedule with different payments over the life of the loan. Your monthly payments can change because of two main factors:
- Changes in your interest rate – An ARM loan
- Changes in your payment structure – An interest only payment period, a balloon payment, a grace period, or a negative amortization period.
Whereas a FRM usually comes with both a fixed rate and fixed monthly payment, an ARM comes with an adjustable interest rate and sometimes with other changes in the payment structure, the most common being the interest only period.
Here are some general features of an ARM:
The name is composed of two numbers, such as a 10/1, 7/1, 5/1. The first number is the initial length of time the interest is fixed, and the second number is the amount of time between interest rate changes. Therefore, a 10/1 ARM has an initial fixed period of 10 years and the interest rate is adjusted every year. (These are the most common, although there are ARMs that fluctuate at different intervals, including every 6 months).
Ceilings: (or Lifetime caps)
ARMs come with protection in the form of ceilings. The ceiling is the maximum interest rate that can be set on the loan during the entire life of the loan.
Periodic Caps are the amount of change that can occur between each interest rate fluctuation. Common caps are 1 -2%. However, many lenders allow the first interest rate change to go as high as the ceiling.
ARMs are readjusted based on different indexes. The most common ones are the 1-year T-bill and the 1 year USD LIBOR. Check with the lender the index that is being offered in your loan and ask for historical data regarding the fluctuations. However, past rates are no guarantee for the future. Margin: Interest rates are readjusted at the index plus a margin. Here are some examples for rates offered in June 2012: 2.25% plus LIBOR for LIBOR ARMS and 2.75% plus T-Bill .
Mortgage loans come with fees, including lender fees such as origination points and discount points. Remember to compare mortgage rates and mortgage fees.
APR (Annual Percentage Rate):
Lenders will provide in their marketing material an APR based on general assumptions and not specific fees. The APR also assumes that you will hold on to the loan for the entire life of the loan, which is generally not the case, especially with a 30-year loan. Also, the APR on an ARM does not take into consideration the various possible rate increases. My recommendation is not to rely on the lenders APR to compare products and offers.
Compare Payment Schedules
Perhaps the simplest way to learn about a 10-year ARM is to compare payment schedules. Let’s assume that you are comparing a $250,000, 30-year FRM at 3.75% to an ARM at these terms:
- 30-year 10/1 ARM
- Initial interest rate : 2.875%
- Lifetime cap is 7%
The FRM will always have a monthly payment of $1,157.79 . Here are some examples of possible payments on the 10 year ARM:
|No Change in Interest Rate (2.875%||10/1 ARM interest rate (annual ceiling is 2%, including first change)||10/1 ARM (initial cap is 7% - worst case scenario)|
|First 10 Years||$1,037.23||$1037.23||$1,037.23|
|11th Year||$1,037.23||$1,235.29 (4.875%||$1,466.49 (7%)|
|12th Year||$1,037.23||$1,443.17 (6.875%)||$1,466.49 (7%)|
|13th Year||$1,037.23||$1,456.18 (7%)||$1,466.49 (7%)|
|Rest of Loan||$1,037.23||$1,456.18 (7%)||$1,466.49 (7%)|
The big advantage of the 10-year loan is the lower initial payments. In the above example you pay $120 less per month for the ten year period. However, against that advantage you carry the risk that the interest rate will increase by as much as 418.95 in the example of 2% hike at each change, and $429.26 in the worst case scenario.
In addition, lenders often charge higher upfront fees for the ARM and lower interest fees for a shorter initial period, such as in a 5/1 ARM.
Evaluate the Pros/Cons – Does the 10-Year ARM Fit?
The biggest factor in deciding if an ARM is appropriate to your situation is evaluating the length of time you will hold on to the loan. If you are planning on moving in the near future, then an ARM may be a cheaper mortgage. Remember to weigh that against the risks of holding on to the loan and moving into a higher interest rate and monthly payment.
Before you choose an ARM make sure that the lender explains to you all the technicalities, especially the type of ARM (10/1, 7/1, etc.), the lifetime cap, the periodic caps and the cap on the initial changes. Make sure you understand the worst-case scenario.
An ARM is especially beneficial if your initial interest rate is lower than a comparable fixed rate loan for the same period. (Maybe you can afford an attractive 15-year fixed mortgage rate). A 10/1 ARM (or even 5/1 or 7/1) is beneficial if:
- You are planning on moving and selling the house before the end of the first period (or even a bit longer).
- You have sufficient income and/or assets to cover the higher payment.
However an ARM carries risks. Some of the cons are:
- You are unable to make higher payments. Some borrowers are tempted to take the ARM (or even an I/O loan) because the beginning payments are affordable hoping that they can later afford the larger payments, or that the payments will not increase. The failure to make timely payments is expensive and can lead to default and foreclosure.
- You are unable to sell the house, forcing you to stick with the ARM loan and swallow interest rate increases, which make the loan more expensive than the original FRM offered.
- Higher initial lender fees. In a mortgage market of low interest rates, such as 2011-2012, fixed rate mortgages are popular. This is especially true for those taking shorter term mortgages, like 15-year FRMs.
However, if you understand and can handle the risks, an ARM, including the 10-year ARM, is a good option to explore.