With interest rates rising, what should you know if you have an ARM?

So, you have an adjustable rate mortgage (ARM). In this article, we tell you everything you need to know in a rising interest rate environment so that you can save the most money and make the smartest decisions, considering your adjustable rate mortgage interest rate.

Determine what phase are you in

Are you in the introductory phase?

Do you still have the initial rate you got, or has your ARM already started adjusting? To find out, first, identify the type of mortgage you have. Is it a 3/1, 5/1, 7/1 or 10/1? If so then the first number is the number of years since you first got the mortgage to when it will first adjust. For example, if you have a 3/1 ARM and got it two years ago, it will adjust next year. Congratulations! You are still in the initial phase. That means you have some time before your ARM starts adjusting upwards.

What you should do about rising rates

Take stock of how many years you have until your ARM adjusts. If you just got a 10/1 ARM last year and have nine years until it adjusts, you should think about two things: 1) are you going to move within nine years? If so, there’s no point in refinancing into a different type of mortgage, like a fixed mortgage as you won’t see any increases before you sell. And, 2) how secure is your situation? If rates were to rise further, could you afford the payments? Is your employment or savings such that it would make refinancing difficult? Will you have enough equity in your home to refinance?

Are you not in the introductory phase?

If you got your mortgage more than the first number of the name of the ARM (for example, more than three years ago if you have a 3/1 ARM), then your mortgage has already started adjusting. For example, if you have a 3/1 ARM and you are in year four, your ARM adjusted for the first time a year ago. Because of this, you’ve likely already seen increases in your monthly payment.

You’ll want to now keep a very close eye on your ARM and understand how and when it might increase.

What you should know about your mortgage

The three components that impact how your ARM adjusts are:

1. How often does your ARM adjust
2. The yearly cap
3. Your index
4. Your margin

1. How often does your ARM adjust?

The second number in the name of your adjustable rate mortgage tells you how often your ARM adjusts. For example, a 3/1 ARM adjusts every year, while a 5/2 ARM adjusts every two years.

2. What is your adjustment cap, or, what’s the maximum amount your mortgage can jump during an adjustment?

In your original mortgage documents you’ll find details on what percentage your interest rate can increase each time it is scheduled to adjust. This number is generally 1% or 2%. This is an important number as during a year of adjustment, your interest rate an adjust up to that amount. A 1% or 2% interest rate increase on top of your usual rate means significantly higher monthly payments.

3. What index is your mortgage tied to?

Indexes are financial tools that fluctuates with the markets. Each ARM product sold is tied to an index. The index determines how much the ARM can fluctuate (within the adjustment cap).

There are three main indexes that ARMs are usually tied to: Libor 12 month, 12-Month MTA and 1-Year CMT. If you click on any of the links, you can see that the rates fluctuate over time. You can look up the index rate for your ARM at anytime. But, your ARM rate isn’t just made up of your index, you also need to know your margin which we will cover in the next section.

4. What is your margin?

Similar to the cap and index information, your original mortgage documents will have information about your margin. The margin is a number which corresponds to what the bank feels is your riskiness to lend to. The margin is usually a number between 2 and 3. The margin is added to the index to determine your interest rate. Margin + index = say hello to your new interest rate! (within your cap, of course ;).

A video that explains it

Do you prefer visual information? Mortgages are very dry and boring to read about. Here’s a video that explains your ARM and how it adjusts:

What you should do about rising rates

How do you feel about your current monthly interest rate, now that your adjustable rate mortgage interest rate is adjusting? Is it putting pressure on you financially? What would happen if your interest rate increased up to your cap (usually 1 or 2%) during the next adjustment? It’s best to plot out the best and worst scenarios so that you can get a handle on your options and don’t get caught in an unmanageable situation. The thing you want to most avoid is a foreclosure situation where you lose out on any equity you’ve built and damage your credit. When ARMs adjust in a rising interest rate environment, many homeowners find themselves in challenging positions. Getting out in front and understanding your options can help you save money and reduce your risk.

Investigate alternatives. What if you refinanced into another 30 year, 20 year or 15 year fixed? If you are a number of years into your mortgage, your remaining loan balance is lower than when you started. So by taking that lower balance and refinancing, you can possibly create affordable payments for yourself, even if interest rates are higher. If you refinance into a shorter term mortgage at a fixed rate, your monthly payments will definitely increase, but your rate will be stable and you will be paying down your mortgage faster.

The best financial choice when considering your ARM is one where you pay less interest and have an affordable monthly payment now and in the future. That can be your north star when looking at your current ARM, and options to your ARM, should you choose to refinance.