What is an ARM Mortgage?

Learn How an Adjustable Rate Loans Can Save You a Lot of Money!

There is a popular new home loan product sweeping the country, called lender paid PMI. It's a brilliant loan program in which the mortgage lender pays the mortgage insurance for the borrower in turn a slightly higher interest rate. In many cases, lender paid mortgage insurance can save the homeowner thousands of dollars a year.

Home buyers who want to save money in the short and medium term might want to think twice about getting a 30-year, fixed mortgage. In the past, the conventional wisdom was to get a fixed rate mortgage because you know that the rate will not change. For people who think more conservatively and like the idea of stability, this may make sense.

But what if you can save yourself money if you are willing to accept some uncertainty? You may want to consider getting an adjustable rate mortgage or ARM, such as a 3/1, 5/1 or 7/1, which also may be referred to as a hybrid ARM. If you are in a situation where getting an ARM makes sense, you may be able to save a lot of money in the long run.

How to Save Money with ARM Mortgage

It is true, though, that ARMs did get a bad reputation of sorts during the mortgage meltdown. If you are feeling a bit nervous about ARMs, let's put some of that to rest by looking in more detail at these innovative loan products.

How 3/1, 5/1, 7/1 and 10/1 ARMs Work

An adjustable rate mortgage does have an interest rate that adjusts. The most common terms are 3, 5, 7 and 10 years. What some people do not realize is that the initial term of 3, 5, 7 etc. years has a rate that is lower than current fixed rates.

So, when you are shopping for a loan, you may hear about a five-year ARM. This means that the rate you get for the first five years will stay fixed for fix years, and may go up or down when that period ends.

When the ARM rate adjusts, the rate is based upon an index, plus a margin that constitutes the profit for the lender. For Fannie Mae and Freddie Mac backed loans, the rate will typically be based upon the London Interbank Offered Rate or LIBOR. Meanwhile, loans that are backed by the VA or FHA have rates that are based upon the Constant Maturity Treasury or CMT.

All ARMs are 30-year loans, so the balance is always re-amortized over the amount of the term that remains when the rate goes up or down.

Misconceptions About ARMs

There are a number of misconceptions about ARMs today that you will want to understand if you are considering one. Many home buyers are nervous about ARMs because they have some misconceptions based upon the negative amortization ARMs of the early and mid-2000's.

Negative amortization loans assisted some ARM mortgage lenders to protect clients from changes in interest rates by letting them make a payment in an amount that was set in the contract. The issue here was if the payment was not enough to cover the loan's interest, the leftover interest was then added to the principal. So, instead of paying down the loan, the client would end up owing more every month.

This put home owners at risk. That is why most lenders today do not offer such loans. The federal government frowns upon issuing loans that can result in negative amortization as it puts the entire housing market at risk.

Another misconception is that the rate on an ARM can go up without limit. This is not true. When you choose your 3/1, 5/1, 7/1 or 10/1 ARM, there are maximum rate caps in place on how much the rate can increase. There is a cap on how much the rate can increase at the time of the first adjustment, and for each year after that. There also is a cap for how high the rate can go up over the entire life of the loan. Even in the worst situation, the rate cannot go up without end.

When Does an ARM Mortgage Make Sense?

When you get a 30-year, fixed rate loan, you are paying more for the higher security. But this security might not make sense in your situation. Consider: Statistics about home ownership show that the average time that people stay in a home is 10 years. Depending upon the conditions in your local market, you may find that it makes sense to do a refinance before even 10 years. In that case, there is a very good chance that you may not even be in the home when the rate adjusts if you get a 10/1 ARM.

If you are going to stay in the home for only five, seven or 10 years, you may be able to enjoy considerable savings over the fixed rate loan. For example, if you have a $200,000 mortgage, let's say you have a 30-year fixed rate at 4.75%. The savings in payments over the first 10 years for a 10/1 ARM at 4% would be $90 or so per month, or $10,800 over the first decade. Not bad.

Remember though that the right home loan for you will depend upon your financial goals and the market conditions when you purchase or refinance. As the rates go higher, the spread between the 30-year fixed rate loan and an ARM will get wider. This will make the ARM more attractive.

An ARM also offers more financial flexibility. Because your payment is lower, you have an opportunity to put that money into a retirement plan or another investment opportunity.

Last, when you are at the end of your fixed rate term, you can possibly refinance the loan into a fixed rate term with a loan amount that is smaller; you have spend years paying down the balance.