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What Are My Risks if I Choose an Adjustable Rate Mortgage?

Updated: Jun 3, 2019

The liquidity crisis that began in 2007 seriously scarred most of us. Very few people want to consider an Adjustable Rate Mortgage (ARM), even if it would save them a substantial amount of money. If you want to consider choosing an ARM, this article will help you assess the risks.

For the record, I got my home loan in 2007. The rate adjusted 5-years later; and my current rate is still lower than fixed rate mortgages. So, ARM’s are not always a bad idea if you plan to keep your home beyond the period the rate is fixed. Your rate may go down rather than up.

There are five aspects of an ARM that should play an important role in your decision as to whether an ARM is a good choice for you. Their relative importance is dependent upon your situation. Here they are:

  1. The likelihood that you will keep the loan beyond the fixed rate period typically 3, 5, 7, or 10 years, (as opposed to selling, refinancing or simply paying off the loan within the fixed rate period).

  2. The Margin is the lender’s profit margin. The margin will be added to the Index to calculate your new interest rate when the loan rate adjusts. Most lenders offer margins ranging from 2.25% to 4%.

  3. The Index to which your loan rate is tied – Index values change on a regular basis. Each has its own characteristics. Most lenders use the 1-year LIBOR index. Some use the Treasury. In my opinion, if you can tie to the Treasury, do that. It tends to be a more stable index.

  4. The Adjustment Caps – These are the maximum increase or decrease percentages your rate can experience when it adjusts. It is expressed as a percentage that is added to, or subtracted from, your start rate. ARM’s usually adjust annually or semi-annually after the first adjustment. There are 3 types of Adjustment Caps:

  • First Adjustment Cap, typically 2% to 5%, (This cap is important. I recommend choosing the lowest first adjustment cap offered, so that your risk of a higher payment on the first adjustment is lower)

  • Subsequent Adjustment Cap – This is the cap on rate changes after the first adjustment

  • Life Cap – This is the greatest change in rate over the life of the loan.

If your start rate is 5% and the Life Cap is 5%, then the highest your rate can go is 10%. The lowest is technically zero, but that is impossible. The adjusted rate = the Margin + the Index value. The Margin is never zero, neither is the Index. If your Margin is 2.5% and the Index value is 0.5%, then your rate will adjust down to 3.0%.

To assess your risk, do the following:

  1. Check an Amortization Schedule to determine what your Principal amount will be when the fixed rate period of the loan ends and the rate adjusts. (There are various ways to determine this figure. If you or your lender cannot determine the principal after the fixed rate period, contact me. I have an Excel amortization schedule that you can customize to your loan.

  2. Go to any mortgage calculator and enter the following:

  • The principal due at the end of the fixed rate period

  • The rate – use the highest your rate can become and the lowest for accurate calculations. To calculate the lowest rate you can expect, use an Index value of 0.5%. It may go lower, but that is not likely.

  • The term of the loan will be the years remaining. For a 5/1 ARM, the term would be 25 years (30-years total loan term minus the years elapsed)

That calculation will show you the highest and lowest payments you can expect when the loan rate adjusts. If you are prepared for the worst, then choosing an ARM may benefit you.

If you have any questions, contact me at or 877-728-2008.

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