With rates constantly in flux, it may be a good idea to start weighing your options. Interest rates have bounced around considerably during the past few years and now could be the time to lock in on a fixed-rate mortgage or refinance into another short term ARM. Often times there is very little difference in rate between longer term ARM products and fixed rate loans. Thus, it may make very little sense to consider ARMs greater than five years in length unless you plan to pay points to buy down to a lower rate. There is no doubt that adjustable rate mortgages serve a purpose and that they can be a great solution for certain borrowers. ARMs are excellent for keeping payments low and freeing up cash for other investments and obligations. However, consumers must keep track of their loan and be ready to refinance it if necessary to ensure that they are not in for a big surprise when their initial fixed-rate period ends.
What will happen to your 3 or 5 year interest-only arm when the first adjustment happens?
Many adjustable rate mortgages have caps of 5/2/5, 6/2/6 or 2/2/6. This means that at the first adjustment, after three or five years, the rate can go up 2-6 percent. That’s right, your rate may adjust from 3.75% to 9.75%.
What will these adjustments do to your monthly payment?
Let’s take a look at one example:
In the spring of 2003, a borrower gets a $400,000 three year interest-only arm with a rate of 3.75%.
The monthly principal and interest payment for the first three years would be approximately $1,250.
Now, let’s fast forward to spring 2006. The loan is ready to adjust and the index that the rate is based upon has quadrupled in the past 24 months (from 1.08% to over 5.060%).
Initial Rate: 3.75%
New Rate (Current Index + Loan’s Margin) 5.060% + 2.75% = 7.810%
The new payment will be based upon the fully indexed rate of 7.810% (The loan is then fully amortized – paying principal and interest) for the remaining 27 years.
Your new payment would be $2,965.84 (more than doubled) and your rate has gone up more than 100% from where you started.