Mortgages come in many different types, and adjustable rate mortgages, or ARMs for short, are popular because they often offer a lower interest rate than a fixed mortgage. However, the trade-off of using an ARM is that interest rates can go up or down over the course of the loan, causing your monthly payments to rise or fall from time to time. To help you plan for what impact rising rates could have on your adjustable rate mortgage, this mortgage calculator will show you what will happen under certain circumstances. Let's look more closely at ARMs and how the adjustable rate mortgage calculator and how it works.
How ARMs work
Adjustable rate mortgages are different from the fixed mortgages that most homeowners are more familiar with. The biggest difference is that ARMs have variable interest rates, and the terms of the loan allow those rates to change from time to time. Each ARM will have an initial period during which the rate doesn't change. After that, though, rates will typically move up or down. For instance, the popular 5/1 ARM has an initial fixed rate for five years, and then rates adjust every year thereafter.
To reduce the risk of major changes, ARMs typically put limits on the amount that the mortgage rate can change. The mortgage terms can put a maximum amount on the adjustment each year, a maximum ceiling rate during the life of the loan, or both. Nevertheless, when rates are low, the ceiling is typically much higher than prevailing rates when you first take out an ARM.
Using the calculator: How rising rates can make an ARM look ugly
To see how this works, say that you want to borrow $200,000 toward buying a home. You can get a 1/1 adjustable rate mortgage using a 30-year repayment schedule with an initial rate of 3%. However, you're worried that rates will likely rise over the course of the loan. We'll assume a steady upward movement of a quarter percentage point each year, with a ceiling rate of 8%.
When you run those figures through the calculator, you can see that your initial monthly payment is $843. However, with assumed rate increases, those payments rise over time. After the first year, when the rate goes up to 3.25%, your payment rises by $27 to $870 per month. If rates hit 4.75%, then your monthly payment will jump over the $1,000 mark. And if the worst happens and rates go all the way up to the 8% ceiling rate at the 20-year mark, then your monthly payment will be a whopping $1,268 -- roughly 50% higher than they were at the beginning of the loan.
Note that the amount of the payment depends not only on the interest rate but also on the outstanding principal balance at the time the new rate is set. For example, if you assume that rates will rise a more rapid one percentage point per year, then the payment after year 5 when rates hit 8% would be $1,416, or almost $150 higher than in the previous example.
Judging your risk tolerance
Obviously, worst-case scenarios aren't likely to happen, and you don't want to gauge your entire mortgage decision on the worst that could possibly occur. However, you also have to assess what the consequences would be if the worst-case scenario did play out. For many homeowners, a $400 increase in monthly payments would be catastrophic. For others, it would merely impose a small financial hardship.
If you're considering an adjustable rate mortgage, make sure you know whether you can afford to take the risk involved in having a loan whose interest rates can vary. If you can't, then assessing your fixed mortgage options is a better bet.