Adjustable rate mortgages (ARMs) are designed for someone who will be in a home for a short period of time, because the fixed rate component does not last through the full term of the loan.
For example, a 3/1 ARM will be fixed for three years and will adjust once every 12 months afterwards. A 5/1 ARM will be fixed for five years and will adjust once every 12 months afterwards. A 7/1 ARM will be fixed for seven years and will adjust once every 12 months afterwards.
Interest-Only ARMs are similar to a traditional ARM. The only difference is that you are allowed to pay interest-only and no principal on the loan.
What happens when an ARM adjusts? Your new rate will depend on two components: 1) a margin that is assigned at the beginning of the loan and 2) an index that changes monthly according to market conditions. Keep in mind that the margin never changes, but the index changes monthly. So if you are in a 5/1 ARM the loan will adjust at the end of the first five years. It adjusts by adding the margin, which was set at the beginning of the loan, to the value index. These two factors combined will determine your adjusted rate for the next year. There is a safety component added, which is called a “cap.” This keeps your rate from shooting through the roof. For example, if today the index were 2% and the margin 2.5%, the “new” rate would be 4.5%.
Always be wary of an ARM that has a negative payment feature. Option ARMs are notorious for this. You will get four payment options, and one of them is going to be very, very low. This doesn’t hurt you for the first few months, but once that rate starts to adjust the lender will continue to give you the option of making that minimum payment based on the initial “tease” rate. However, the lender is going to take the difference between what you elect to pay and your actual payment and add it to the loan balance in the form of negative amortization. Be careful with these programs! You will progressively owe more, not less, on your mortgage than when you first started paying down the loan.
Regardless of the type of loan you select, choose it with no closing costs. When you are not investing thousands of dollars in a loan, there is no barrier to refinancing. If one of these products becomes too aggressive or puts you in a bad position financially, we will take you right out of it and into a different type of mortgage, once again with zero closing costs, assuming that you qualify for it.