What Happens When Your ARM Resets

Many homeowners have an ARM, or Adjustable Rate Mortgage. This kind of home loan has an interest rate that changes over time in reaction to market conditions.

A common way to set the rate is to tie it to the predominant interest rates that lenders are using, like the US Prime rate. This is called indexing; the mortgage rate might be “indexed” to the Prime rate, LIBOR (London Interbank Offered Rate) or some other rate. In addition to the index, the borrower pays a margin, which is agreed between the lender and the borrower when the loan is written. A borrower might pay a 5% margin on top of the index used. If the index was the US Prime rate, which is currently 3.25%, then the borrower would pay a total of 8.25% on his/her ARM.

If the indexed rate adjusts, then the rate the customer pays goes up accordingly.

An ARM might have limits to how much it can increase and how often. For example, an ARM might only be able to go up every 6 months. ARMs also commonly have lower introductory or “teaser” rates that last for the first few years of the mortgage—up to five years in some cases. The rate can adjust upward dramatically after the introductory period ends.

Why people choose ARMs

  • An arm often has the lowest rates available during the introductory period, better than conventional 30-year mortgages.
  • If a borrower doesn’t expect to stay in a mortgage for very long, s/he might choose an ARM as a more affordable short-term option.
  • Financially savvy borrowers might plan to refinance at the end of the introductory period to avoid the rate increase.
  • ARMs can adjust downward. If the index rate goes down, then the rate one pays on an ARM goes down, too.

Obviously, ARMs come with a big potential disadvantage; when the teaser rate ends, borrowers are hit with a rate hike that can be hard to afford. As we said above, many financially savvy borrowers plan for this and refinance at the right time. But when market conditions change (as they have in reaction to the ongoing financial crisis), it can be harder to refinance.

Luckily, rates are very low right now in general, so the damage is limited. But as rates rise, the danger of an ARM rate reset will be greater.

What to do when the rate resets
If you’re having trouble getting refinanced and a big rate adjustment is imminent, there may be government programs that can help. The Home Affordable Refinance Program is one such option.
Another loan reset that borrowers face is a HELOC Reset. See “What you should know about HELOC reset” for more information.

A HUD approved housing counselor can help you explore your options and decide what the best course of action should be. Assistance is available free on demand. Call us today to talk to a certified counselor and ensure you’re ready for any changes to your mortgage rates.