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Adjustable Rate Mortgages are much maligned and misunderstood but they can be a very useful tool in your financial plan. Adjustable Rate Mortgages are generally offered with a better rate than the fixed mortgage rates of the day, and therein lies the temptation. For example, last week, First New England Mortgage offered a 30 year fixed rate of 3.625% with zero points and a 5/1 adjustable rate mortgage for 2.75%. On a $300,000 loan, that’s a savings of $143.43/month. That’s a difference with a savings of $8,605.80 over five years.

Why have adjustable rate mortgages (ARM’s) gotten a bad rap? Well, during the mortgage meltdown at the end of the last decade, and as the housing bubble came to an abrupt halt, many of the sketchy mortgages written happened to be an adjustable rate of some sort or another. There were too many variations to go into in this context, but trust me, they were pretty creative. Clearly, adjustable rate mortgage is not for the faint of heart. You need to be certain that you’ll be able to handle increases in your payments at some specified times in the future. I think many of us have even enjoyed downward adjustments in recent years.

Some of the features of adjustable rate mortgages are the initial start rate below market fixed rates, the initial fixed rate term, adjustment and lifetime rate caps for your protection, index, margin, and ability to recast your mortgage when you’ve made prepayments:

• Start Rate - This is often called a teaser rate but it’s often substantially lower than fixed rates.
• Initial Fixed Term - Your initial Start Rate is fixed for an initial term, usually 3, 5 or 7 years.
• Adjustment Interest Rate Caps - The most common interest rate adjustment cap is 2%. This means that your interest rate will not increase or decrease by more than 2% for any one adjustment. Sometimes the first adjustment following your initial fixed term will allow for as much as a 5% adjustment with subsequent adjustments capped at the regular 2%.
• Lifetime Interest Rate Cap - This limits the most that your interest rate could ever increase or decrease and at today’s writing, the standard is 5%. Often times there is a floor of 2% so your rate might never actually go lower than this.
• Index - This is a rate usually published by the likes of The Wall Street Journal, like the 10 year treasury bill, or the now controversial LIBOR, that is used to determine how your interest rate will adjust.
• Margin - This is the amount added to the Index that is used to determine your interest rate, commonly about 2.75 to 3%.
• Fully Indexed Rate = Index plus Margin - Add these together and make sure the increase or decrease from your current rate does not exceed your caps, and this is your new adjusted rate.

So a quick example. Let’s say you chose to take a 5/1 adjustable rate mortgage of 2.75% on a $300,000 loan. Your payment will be $1,224.73 and will be fixed for the first 5 years of your mortgage. At the end of this first 5 years, let’s say the index is the 10 year treasury bill is 1.67% (today’s rate). Your new rate would be determined adding the margin of 3% to this index of 1.67% and would be 4.67%, rounded up to nearest 1/8th, to 4.75% to get your Fully Indexed Rate. Assuming this does not exceed your cap of 2% (just so happens it is exactly 2% in this example) this will be the rate used to determine your new payment. Your new payment is also going to be based upon new factors including the interest rate we just calculated, the remaining term of your loan, and the current outstanding balance of your mortgage. So in our example, assuming you made no prepayments, your outstanding loan balance after 5 years would be $265,487.70, with 25 years remaining, and a new interest rate of 4.75%, your new payment would be $1,513.60.

This recasting of your mortgage terms at each adjustment allow you to manage your future payments a little bit. If you prepay anything toward your mortgage, your new payment is made based upon this lower loan amount at each adjustment period.

As always, I’m happy to do the math for you in more detail if you’d be so kind as to drop me an Email. You can also call me at 800-641-1715

This is a very high level and simplistic view of adjustable rate mortgages. You should speak with a qualified loan officer to get a fuller understanding before you jump.