An adjustable rate mortgage (ARM) must start out lower than a fixed rate mortgage. An ARM is tied to an index (normally LIBOR or Treasury, sometimes Prime or Cost of Funds) and has a margin 2.25% – 2.75%. So whereas today’s 1 year LIBOR index is 1.04% and the bank’s margin is 2.25%, the fully indexed rate is 3.29%, rounded up to nearest eighth means the fully indexed rate of this ARM is 3.375%.
However banks will discount the initial fixed period of this ARM and you may be able to achieve a 5/1 ARM @ 3.00%, 7/1 3.125%, etc. (See below rates.)
The ARM has “caps”. The cap is the maximum the rate can increase after its initial fixed period and then annually thereafter and the most it can increase in the life of the loan. 2/2/5 Caps means it can’t increase by more than 2% above where it starts after the intial fixed period and then cannot increase by more than 2% annually thereafter, NEVER to increase by more than 5% over the start rate in the life of the loan.
The fixed rate mortgage will be a bit higher, today fixed 30 @ 3.875% – 3.99% but will never increase. When the fixed is so close to the ARM the vast majority of people take fixed rate mortgages. Interestingly so, I have never had a fixed rate mortgage on my primary residence. I do on my investment properties but not on my primary.
In order to keep payments low initially the ARM may be a good strategy. But as the rates are not that much of a savings it may behoove people to rethink their buying strategy and negotiate a bit lower price.
A $400,000 loan at 3.99% fixed 30 is $1,907.36/month.
Same 5/1 ARM is $1,686.42/month. A buyer might feel they want to be closer to $1,800/month and might not feel secure in having an ARM fixed in for only 5 years.
As such the same 30 year fixed getting closer to $1,800/month might mean borrowing closer to $380,000, payment would be $1,811.99/month. $20,000 negotiated difference makes buyer better prepared to move forward.
Bottom line, options always exist. Talk to your mortgage and real estate professional to help navigate the maze.