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What Is an Adjustable Rate Mortgage (ARM)?

August 1, 2018 | Posted by Demian Farnworth

You might be surprised to discover that before the Great Depression only four in ten people owned their home. The rest rented–for good reason.

Most mortgages during this time limited loans to 50% of the home’s value. In addition, these loans ranged from three to five years in length, then ended with a balloon payment (which amounted to the entire principal of the loan). These loans were simply out of reach for most Americans. The Federal Housing Authority (FHA) wanted to change that.

So, in 1934, wanting to do their part in helping pull the U.S. economy out of the Depression, the FHA did a few things:

  • They lowered the down payments required to get in a home by offering 80% to 90% loan-to-value mortgages. In other words, homeowners needed way less money for a down payment.
  • They qualified people based on the ability to pay–not on who they knew.
  • They lengthened the terms of home loans from five to seven years to fifteen and eventually thirty-year mortgages.

And it pretty much stayed that way until April 30, 1980.

On that date Brooklyn filmmaker and real estate investor George Avgerakis sold 38 Green Avenue, Brooklyn, NY. It’s thought to be the first privately-issued adjustable-rate mortgage in the United States.

Introducing the Adjustable Rate Mortgage (ARM)

The best way to talk about an ARM (sometimes referred to as variable rate) is to compare it to the more popular fixed-rate mortgage.

The biggest difference between the two is that the interest rate stays the same during the life of a fixed-rate loan. An ARM, on the other hand, starts out with a set interest rate. The set rate period for ARM loans can last from 3 to 10 years. When that period ends, the interest rate adjusts periodically.

It adjusts based upon the index or a broader measure of interest rates it is bound to. The London Inter-Bank Offer Rate (LIBOR), 11th District Cost of Funds and Treasury Constant Maturities are common indexes used.

When the index goes up, so does your payment. But just because the index drops doesn’t mean your payment will go down, too. This is why it’s important to clearly understand how your ARM works.

The benefits behind an ARM

Your monthly payment tends to be lower. Lenders generally charge lower initial interest rates for ARMs than for fixed-rate mortgages. At first, this makes the ARM easier on your pocketbook than would be a fixed-rate mortgage for the same loan amount. You could also save money over the life of the loan if the index interest rate didn’t ever move or drop.

For this reason, ARMs are often a good choice for homeowners who plan to sell after a few years.

Let’s say you don’t plan on moving. In fact, you know your income will rise in the next five years. Either through a promotion or your spouse getting a promotion. Then the idea of saving money now and creating a little nest egg with lower payments sounds appealing. You just have to be comfortable with making higher payments down the road when the ARM adjusts and possibly goes up.

However, no matter how much money you make, there is a possibility that interest rates might rise to a point where you can no longer afford them. If that’s a risk, avoid buying the home–or make sure you are out of the house before the rate resets.

Answer these questions before you consider an ARM:

  • Will your income be enough to cover a higher mortgage payment if the interest rates go up? Do you expect to make more money in the future?
  • Will you take on additional substantial debts like a school or car loan?
  • How long do you plan on living in the house?
  • Do you plan on paying the loan off early?
  • Do you know how high your interest rate and monthly payments could go with each adjustment?
  • Do you know how often the interest rate will adjust?
  • Do you know how soon your payment will go up?
  • Is there a cap on how high the interest rate will go up?
  • Is there a limit on how low the interest rate could go down?

To lower your risk, make sure you know the answer to these questions before you commit to an ARM. And when in doubt, go with a stable fixed-rate mortgage.

Residential loans through LCEF

LCEF is pleased to offer residential loans to LCMS Rostered Church Workers (RCWs). See our fixed-rate and ARM options.

By the way, LCEF does not set its loan rates to an index. Instead, we use our cost of funds as a basis for setting loan rates. In doing so, we have more control over the rates offered to borrowers. Learn more about how we set loan rates based on cost of funds here.

 

 

AUTHOR
Demian Farnworth
Senior Content Writer for the Lutheran Church Extension Fund.