Adjustable rate loan-is that a good idea for me?

Let’s start with the basics. An ARM would be any loan where the interest rate can change or adjust during the term of the loan. Some ARM’S adjust every 6 months; some once per year; others every three, five or seven years. In recent years lenders have added a “hybrid” loan product. During the first several years (usually until the 3rd, 5th or 7th year) the interest rate is fixed at a rate generally 1 or 2 percentage points below market rates, then when the subsidized period comes to an end, the loan will adjust to the then current market rate.

How often and by how much can an ARM adjust? This gets a little complex, but it is important for you to understand. Common to ARM’s are 3 things: 1. The index rate; 2. the margin percentage; and 3. the cap. The rate being charged on your loan is the sum of the index rate and the margin rate. Different lenders use different indexes. Some use the 1 year US Treasury bill rate; some use the LIBOR rate and others use the 11th District Cost Of Funds Index (COFI). The important point is that the index is not controlled by the lender. The margin, which is controlled by the lender, is a fixed percentage that would be added to the index rate to get the actual rate charged to you. That actual rate, however is subject to the effect of the cap, of course. I have seen margins as low as 2.0% and others as high as 4%. Caps are of two kinds: 1. the most a rate is allowed to adjust at any one interest rate change; and 2. a lifetime cap which is the highest interest rate the loan can ever carry. Other things being equal, the lower the margin the better the loan is for the borrower. Most ARM’s have a 2% cap in any one year and a 5 or 6% lifetime interest-rate-change cap. Since ARM’s have a subsidized or especially low rate at the beginning, it is important to know the margin, index and caps.

Who are good candidates for ARM loans? The most obvious are those people who will likely be transferred or for some reason already know that they will not be in the same house more than 3 to 5 years. Another possibility would be people who know their income will be rising or who know their expenses will be dropping in the near future. A young family that currently has one spouse making a wage while the other raises the preschoolers, could be ideal, since the non-wage earning spouse plans on re-entering the workforce when all the kids start school thus raising the total family income. Another good situation would be a family that wants to buy their retirement home now, but not move in for several years. Obviously, since they would own 2 homes, they have created a situation where they will be making 2 house payments for a while. The ARM allows for a reduced interest rate and a lower monthly payment amount at the beginning. Then, when they sell their primary home, they could apply the proceeds from that sale, to reduce the principal amount owed on the ARM loan. A unique aspect of ARM’s is that when the rate is adjusted the loan is re-amortized over the remaining term of the loan. Hence, large lump payments will significantly lower the monthly payment but not affect the length of the loan. Compare this to lump payments on a fixed rate loan where the extra cash merely shortens the term of the loan but it does not reduce the size of the monthly payment.