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Adjustable Rate Mortgages Explained

What are the pros and cons of adjustable rate mortgages? Adjustable rate mortgages, or ARMs, are loans where the interest rate will rise after a certain period of time. Should I, as an investor looking to buy an investment property, get an adjustable rate mortgage?

No, it's better to take a loan of a longer period of time unless you have money saved and are more than prepared to pay a higher interest rate in the future. Still though, ARMs force your hand as an investor, making you pay more money on the loan if you don't sell the property or pay more interest when you might be in a much different financial state five years from now.

Adjustable rate mortgages:

Pros:

  • Lower interest rate - save money
  • Cheap interest rate if you don't plan on living in the property for long

Cons

  • Rates go up - sometimes much higher and might just surprise you when you aren't ready
  • ARMs are hard to understand
  • Low rates means you might not pay down much principal

Fix-rate mortgages:

Pros

  • Constant interest rate - no surprises
  • Simple to understand

Cons

  • If rates of interest are high, then cost much more over the life of the loan
  • Every lender offers same rates, usually, so not much variety

ARM. Those three letters have become tantamount to a four letter word or a jail sentance after the housing crisis. Adjustable Rate Mortgage was really the worst possible thing you could have done when you bought a property during the housing crisis five or six years ago.

But here is information that will help make these three letters (ARM) clear and help you choose the mortgage that's best for you. Also, make sure to find out if the loan you're getting has an pre-payment penalties or rules on whether or not you can refinance the loan.

Adjustable or Fixed-Rate Mortgages?

Determining whether to choose an adjustable rate mortgage or a fixed-rate mortgage can be confusing.

It's important to consider what mortgage rates are doing. The rates for adjustable-rate mortgages (ARMs) are determined in part by the actions of the Federal Reserve. If the Fed raises rates, it would be wise to choose a fixed-rate mortgage. If the Fed lowers rates, ARMs may have more attractive rates and you should weigh the option of having an adjustable-rate mortgage.

Usually, adjustable-rate mortgage will have an initial rate for a period of time, say five or six years. Sometimes this is called the teaser rate, which is quite low but then goes much higher after that period of time. So, if you have an adjustable rate mortgage you have to be ready to sell your property or adjust your mortgage rate.

This is from Bank of America's ARM info page:

Most lenders today offer a “hybrid ARM,” or “fixed-period ARM,” which features an initial fixed interest rate period, typically of 3, 5, 7 or 10 years. After the introductory fixed-rate period expires, the interest rate becomes adjustable for the remainder of the loan term.

So, as an investor, you have to plan ahead and be ready for the loan's interest rate to change. Is it worth it to you to save money early on but then be hit with a rate increase? This is something you have to think long and hard about, since it's tough to know what the future holds.

Another thing to consider is what kind of real estate investor are you? If you're just starting out, it's better to avoid risk, go with the fix-rate mortgage. Also, what kind of relationship do have with your lender, have the loaned you money before? If so, then accepting a ARM at 10 or 15 years is less risky since you've worked with the lender and they want to keep you as a customer - there more likely to work with you if there's an issue down the road.

Remember: Below are some key terms for an adustable rate mortgage. When deciding to go with ARM, don't just look at the initial interest rate, make sure you pay close attention to the index rate, margin rate and the CAPs for the loan.

Index: Most interest rates are based on the London Interbank Offered Rate (LIBOR), which is what banks charge to lend money on a short term basis. The index can also be set to the one-year U.S. Treasury interest rate. The lender/bank also adds on what's called "margin". This margin is set by the lender or the bank and is constant throughout the life of the mortgage. This margin is something you can negotiate.

For example: 1.5% (LIBOR) + 2.0% (margin) = 3.5% (your rate)

Initial Cap: This cap sets how much the interest rate can adjust after the fixed rate period on the ARM. So this is for the first interest rate change when the ARM adjusts, so say after 5 years of a fixed rate mortgage.

Periodic Cap: Sets out how much the interest rate can change from each adjustment period after that first change.

Lifetime Cap: This cap is about how much the interest rate can rise in total for the life of the mortgage. Usually it's not more than 5%.

What exactly are the CAP numbers the bank gives you?

Usually CAPS give you three numbers for the mortgage adjustments that occur through the life of the loan:

The three caps look like this: (2/2/5 or 5/2/5)

First number is the initial cap, when loan adjusts after the fixed rate.

Second number is the annual cap that will occur each ensuing year.

Third number is the lifetime cap, just how high the interest rate can go.

Here's a quick example of how caps determine your interest rate once the fixed rate period ends:

Let's say you have an ARM that's 5/1. That (5/1) means the interest rate and payment stay the same for 5 years on a 30 year loan. Once the 5th year ends, the interest rate on the loan will adjust, or change every year through the life of the 30 year loan. Yes, that can be a very stressful thing to have to worry about with a ARM.

So, for the first the interest rate on your loan is 4.0%. Sure, that seems quite good for now. And you have that same interest rate for 5 years. Then, once the 6th year begins, the lend or the bank will look at the LIBOR rate (which is, let's say 5%), and the bank or lender will adds their set margin rate that was determined when you signed the loan contract, 1.75%, so your new rate will be 5% PLUS the margin of 1.75% which is 6.75%.

And that is for the whole year until the next year, the 7th year where the lender will add the LIBOR and the margin once again to determine your new interest rate.

Learn more at: Adjustable Rate Mortgage Help.



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