If you’ve been reading about the real estate and mortgage industry lately, I’m sure you’ve heard about how bad Adjustable Rate Mortgages (ARM’s) are and how people are “stuck” in them.  But once again, this is where generalizations in the media do not give you the whole picture.

Did you know out the trillions of dollars of ARMS set to reset this year a good chunk of those may actually adjust lower?  Some people who are being persuaded to switch into a fixed loan may actually be giving up additional savings for no reason.

I’m not saying ARMS are for everyone, and there are some ARMS that are just plain terrible, but if you look closely and do some careful planing, an ARM can provide great savings.

For the past two years there has really been no demand for ARMS as the bond markets were experiencing an inverted yield-curve (meaning short term rates were actually higher than long term rates) but now with the recent interest rate cuts by the federal reserve the spread has widened and ARMS once again are something to consider.

Let’s look at today’s rates for an example.  A 30 year fixed mortgage closed today at around 6.25%, while a 10/1 ARM (meaning your rate would be fixed for 10 years before it adjusts) sat around 5.375% and a 5/1 ARM was right at 4.875%.  

Since the average family tends to move every 5-7 years, a family not planning on staying in their home for more than 10 years might want to look closely at an ARM.

When considering an ARM you need to look at three IMPORTANT  details:  the index, the margin, and the caps.  This where you’ll discover that all ARMS are not created equal. 

The index is just that…and index used to track rates.  The two most commonly used indexes fro ARMS are the 1-Year CMT Index and the 1-Year LIBOR index.  These indexes are usually easy to find on the internet or in a publication such as The Wall Street Journal. Currently the 1-Year CMT is around 2.75%, compare this to January of 2007 when it sat at over 5.00%.

The “margin” (or spread) is what the lender adds to the index to determine your interest rate.  A common margin for conventional ARMS is around 2.25%.  So if your ARM was based upon the 1-Year CMT (2.75%) with a margin of 2.25%, your FULLY-INDEXED rate would be at 5.00%.  If your ARM is getting ready to reset, pull out your paperwork and look for your index and margin in your note and determine if your rate is going to go up or down.

The last part of the equation in evaluating ARMS is the term CAPS.  There are typically two CAPS to be aware of; the first is the ADJUSTMENT cap, and the second is the LIFETIME cap.  The adjustment cap limits the change to your rate at the time your rate adjusts, and the lifetime cap is the total your rate can adjust over the life of the loan.  Here’s a common way for caps to be presented…2/2/6.  In this example the first number is the increase (or decrease) that your rate could adjust on it’s FIRST adjustment, the second number is the cap on which the rate can adjust on each subsequent adjustment, and the final number is the lifetime adjustment cap for your rate.  If your start rate was 5.00% on a 5/1 ARM with these caps, at the end of five years your rate would be determined by adding the INDEX at that time plus your MARGIN, but capped not to exceed more than 2.00% higher than your start rate, so your rate would not increase on this adjustment to more than 7.00% at that time.

As you can see, there is a lot to look at when considering an ARM, but with careful planning and a little education ARMS can provide big savings over fixed rate mortgages and should not be considered taboo just because of what you might read, see, or hear from the media.