Kofi has a 7.25% fixed-rate mortgage but was recently offered a “teaser” 6.2% 5/1 adjustable rate mortgage (ARM). He’s 30 years old and living in what he considers his starter home. His career is going well, he makes an above-average income and he expects to get regular bumps in his paycheck as he climbs the corporate ladder.
Still, he’s concerned about how the policies of the current administration might affect the economy. And he’s uncertain whether it makes sense to take on an ARM amid all this uncertainty.
The lower rate of an ARM may be appealing, but there are several factors he’ll want to consider before switching. Here’s what you need to know.
An adjustable rate mortgage, or ARM, is a mortgage that starts out with a fixed rate (usually below the rate for a fixed-rate mortgage) and then the rate resets at a specified period. For example, a 5/1 ARM has a fixed rate for five years and then the rate resets each year after that.
The fixed interest rate term is commonly set at three, five, seven or 10 years.
The reset interest rate is equal to an interest rate based on an index plus a margin. For example, if the index is 4.25% and the margin is set as 1% above the index, the new rate will be 5.25%. If the index is 6% at the next reset date, the interest rate on the mortgage will be 7%.
Some indexes used to determine ARMs include the prime rate, Constant Maturity Treasuries (CMT), Cost of Funds Index (COFI), the 12-Month Treasury Average (MTA) and the Standard Overnight Financing Rate (SOFR). Most ARMs include caps on how much the interest rate can change at any reset and how high it can be set over the term of the loan.
ARMs are generally suited to people who plan to move or pay off their mortgage before the end of the fixed period. They’re also suited to those who believe interest rates will go down, but are willing to take some risk that they won’t — or who expect their income will increase enough to accommodate the potentially higher payments that may occur later.
Data shows only about 8% of Americans have ARMs; and they tend to be more popular with younger, higher-income households with big mortgages.
