Why an ARM?

The other day I read in Scott Burns’ column in the Dallas Morning News as a reader was asking about ARM’s.  I like to read what Mr. Burns has to say on all subjects but do listen more when he gives mortgage advice.  The reason: I have yet to read him give bad advice.
ARM style loans came out in the 1980’s here in the States when the interest rate market was through the roof.  You might be surprised if you ever move overseas and want to purchase a home. ARM’s are very popular in the United Kingdom and elsewhere.  An ARM has a fixed and an adjustable time line.  They are available for 1 year, 3 years, 5 years, 7 years and even 10 years.  Those numbers represent the length that the loan will be fixed.  After that time, the interest rate can either go up or down depending on the details of that ARM program.  Most ARM’s are amortized over a 30 year loan period.  Each ARM has what is called a margin and an index.  A margin is a number given by the lender that stays with the loan and helps calculate what the rate will be during the adjustable timeframe.  An index is what that the ARM follows.  It could be the LIBOR 1 month, 6 month or 1 year; the MTA; or one of the Treasury options.  Now for the complicated part: an ARM will have a floor and a ceiling with limits as to how much the rate can go up or down depending on the index to which the loan is tied.  Some say no more than 2 points up or down at the first adjustment and no more that 5 total, but all of those details vary and you want to know all of that information before you get to the closing table.
For example, you are in a 5 year ARM and the 5 year’s are up.  A few months before the anniversary date would be a good time to dig out the closing papers that the title company gave to you as they have all the details you need.  Minor details will be on your monthly mortgage statement but the real info lies in the papers.  You want to look and see what your margin, index and details are so you can decide if staying in that loan at time of adjustment is the correct move.  Say you are in a loan with a 2.25% margin (most are) and follow the LIBOR 1 year index.  Head to the internet to find out what that index is trading. At the time of this writing it was 1.381%.  Add that to the margin and your new rate will be 3.63%.  Now look at the details. If your beginning rate was 5% and your contract says that it may move no more than 1% up or down, you would have a 4% rate for that next 12 months.  Repeat those steps each year, making sure that the index is not trading in a way that would make your rate unbearable.
The person in the above example made a good move by picking the ARM program as their rate dropped, but what about if we were not in a falling rate environment?  What if, while in that loan, their FICO score dropped as did their home value, making a refinance impossible?  ARM’s are never the problem; it is the details and the knowledge that goes with them.  Just like anything else in life, buyer  beware and know what you are getting into. 
Have an ARM story you would like to share with me?  Send it over. I’d love to hear it.

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