“Be aware, be educated before you jump in,” said Linda McCoy, president of the National Association of Mortgage Brokers.
Here are questions and answers about adjustable-rate mortgages:
What does it mean when an ARM is advertised as a 5/1, 7/1 or 10/1?
The first number refers to the fixed-rate period (five, seven or 10 years). The second is the number of times the rate can change after the flat-rate period — once each year, in these examples. But loans with rates that can change every six months are also common. They are typically cited as 7/6-months, 10/6-months and so on.
Some loans allow a larger increase at the first reset — often, five percentage points above the starting rate — then allow increases of no more than two percentage points, said Sean Bloch, a mortgage broker on Long Island. Some lenders underwrite ARMs based on the borrower’s ability to make payments at the initial fixed rate plus two percentage points, he said.
Most ARMs also put a cap on the total increase over the life of the loan. So if the initial fixed rate is 4 percent and the cap is 5, the rate can’t go higher than 9 percent — but that still makes for a much higher monthly payment.
When does an ARM make sense?
If you are confident that you will remain in the home for a relatively short period — less than the loan’s fixed-rate period — an ARM may make sense. You can sell the home or refinance the loan before the rate is reset. People who can realistically expect a significant increase in salary before the reset — like medical residents or law students — may also benefit, Ms. McCoy said.
But the option may be too risky for, say, hourly earners looking at an adjustable-rate loan as the only way to afford a specific home. “I’m not going to give them an ARM,” she said. They could lose the house, and much of their investment, if they can’t make the higher payments.
Ultimately, it comes down to your comfort with risk, said Dr. Seay at Kansas State. “I have a low risk tolerance,” he said. “I would never have an ARM.”
Can the interest on an ARM be reset to a lower rate?
Yes. After the initial repayment period, ARM rates are based on a benchmark market index and a set rate known as a margin. So if the index falls, the rate on the loan can, too. But many loans have a floor below which the rate cannot fall. Ask your lender or review your loan disclosure documents to find out what that rate is.