An Adjustable Rate Mortgage (“ARM”) is a loan whose interest rate changes based upon market conditions, after the time period of the initial fixed interest rate expires. As the name suggests, an ARM is fundamentally different from a fixed rate loan because with an ARM, the interest rate will vary and with a fixed rate loan, the interest rate stays the same for the life of the loan.
- An ARM is typically amortized over 30 years.
- An ARM includes an introductory fixed interest rate that can last anywhere from one to 10 years.
- The introductory interest rate is lower than a fixed rate loan, which enables a homebuyer to potentially purchase a more expensive home.
- Once the introductory fixed rate of an ARM expires, the adjustable rate begins – also known as the reset.
- The timing and frequency of a reset vary and are defined in each loan’s specific structure.
- The adjustment may result in an increase or decrease in monthly mortgage payments.
How ARMs Work
- All ARM loans have a “margin” plus an “index”. Margins on loans typically range from 1.75% to 3.5% depending on the index and the amount financed in relation to the property.
- The index is the financial instrument that the ARM loan is tied to, such as: Libor Rate (London Interbank Offered Rate), Fed Funds Rate, One-year Treasury Security, Prime, 6-Month Certificate of Deposit (CD) or the 11th District Cost of Funds Index (COFI).
- When it comes time for the ARM to adjust, the margin will be added to the index and is typically rounded to the nearest 1/8 of one percent to arrive at the new interest rate. That rate will be the fixed interest rate amount until the next adjustment period.
- There are factors that limit how much the rates can adjust. These factors are called “caps”. For example:
Loan Structure – “3/1 ARM” (30-year mortgage with a 3-year introductory rate and an adjustment interval that occurs once every year thereafter the introductory period), with an initial cap of 2%, a lifetime cap of 6% and an initial interest rate of 3.25%.
Loan Cap – The highest rate the borrower could have in the fourth year would be 5.25 and the highest rate the borrower could have during the life of the loan would be 9.25%.
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