CNC Mortgage Blog

Adjustable rate mortgages ( ARMs) got a bad name during the sub prime crisis. These mortgage products can be the right product for certain home owners.

The traditional ARMs that are attractive again are fixed for an initial period of time and then adjust by a predetermined calculation. Traditional ARMs are called 3/1, 5/1, 7/1 or 10/1 ARMS. This means that the mortgage is fixed for an initial period of one, three, five or ten years, after that time the rate will adjust once a year based on a recognized index plus a margin. The loan will be amortized over 30 years.

The index can be an indicator like the LIBOR (London Interbank overnight rate),the COFI (Cost of Funds Index), the PRIME rate or other index that the lender can offer. This month the LIBOR is close to 1.1%. If the lender is charging a margin of 2.5% and your mortgage were resetting today your rate would be fixed at 3.6% for the next year.

The changes that can occur to the ARM after the fixed period are usually that they have a maximum rate adjustment of 5% ( called a cap) over the initial rate. That can happen one time at the first adjustment or gradually over the life of the loan. The rate could also go up or down by 2% per year up to that maximum. So that maximum would be 8.875% if the initial rate were 3.875%.To reach 8.875% the LIBOR rate would have to be at 6.625%. The last time the LIBOR was over 6% was in September of 2000.

Who should consider an ARM? On average people keep a mortgage loan seven years. This average has been going down. People no longer stay in the same job forever, they change jobs. Young first time home buyers usually are advised to get a 30 year fixed mortgage (I suppose by their parents who had the same). Chances are very slim that they will be in their first house for 30 years; they might change jobs, have children or simply want to move up from a “starter home.”

A family whose youngest child is in high school will probably be feeling the empty nester syndrome as that child will be graduating from college in about seven years. At that time they will probably consider moving to another house.

Of course the only reason to consider an ARM over a fixed rate is if the payments will be lower. A $200,000 30 year fixed mortgage at 4.75% would pay $1,043.29 for principal and interest. That same mortgage on a 7/1 ARM at 3.875% would pay $940.47. There would be monthly savings of $102.82, $8,636.88 during the initial 84 months of the loan. On a $300,000 loan the savings would be $12,956 in the same 84 months.

So, don’t dismiss an ARM without considering how long you will be in the house.