What is Adjustable Rate Mortgage?
An adjustable rate mortgage (ARM) is a mortgage whose rate changes at some pre-determined interval. The interest rate will be based on the combination of an index and margin. The index is the current market rate such as US Treasury Bill, Prime Rate or London Inter-Bank Offer Rate (LIBOR). The margin is a premium added to the index. Together, the index and margin comprise the interest rate quoted to the borrower. The index may vary up or down from one adjustment interval to another. The margin will remain the same for the life of the mortgage. Somewhere in the fine print will also be a term called mortgage floor. The floor is a rate the loan mortgage never fall below. There will also a term called cap. There will typically be two caps; an adjustment cap and a lifetime cap. The adjustment cap is the maximum amount the interest rate may adjust at any adjustment interval. The lifetime cap is a maximum interest rate the mortgage can never exceed regardless of adjustments.
If staying in the same home for 30 years is not in your plans, an adjustable-rate mortgage (ARM) may be right for you. An ARM generally offers a lower initial interest rate than a fixed-rate mortgage. With lower monthly payments in the initial years of your mortgage, you may qualify for a larger ARM mortgage than you could with a comparable fixed rate mortgage.
If one or more of these situations describes you, an ARM might be a good fit:
- You plan to stay in your home for a relatively short period of time You're a first-time homeowner -looking to move up, yet unsure of how long you'll stay in your new home.
- You want lower initial monthly payments and can handle potential payment increases in the future.
- You want to qualify for a larger mortgage amount, and you expect your income to go up over time.
Adjustable Rate Mortgage Features
You can select an ARM with a fixed-rate period of up to 10 years. The interest rate and your monthly payment stay the same during the fixed-rate period. After that, the interest rate adjusts (usually annually) based on a specific financial index -- for example, one frequently used index is tied to the price of U.S. Treasury bills or securities. Another popular index is the London Interbank Offer Rate (LIBOR). In addition to the index, an additional percentage, known as a margin may be added to the index value to determine your interest rate at the time of adjustment. The rate moves up or down, depending on how interest rates have moved since you took out your loan. This means that when interest rates go up, your monthly mortgage payments may go up as well. On the other hand, when interest rates go down, your monthly mortgage payments may also go down. ARMs typically have an interest rate cap (or maximum) on the periodic adjustments and for the life of the loan. So, you know that your monthly payment can never increase above a certain amount. ARM's fall into two main categories; amortizing and interest only. With an amortizing ARM, each payment includes principle and interest. With an interest only ARM, just interest payments are made during the interest only period.
Adjustable Rate Mortgage Terms
Adjustable-rate mortgages (ARMs) are popular because they usually start with a lower interest rate and a lower monthly payment. The lower rate (and lower monthly payments) may also allow a higher loan amount. However, the interest rate can change during the life of the loan, which would mean that your monthly payment would increase (or decrease).It's important to understand the specifics of an adjustable-rate mortgage, commonly called an ARM: Adjustment periods - All ARMs have adjustment periods that determine when and how often the interest rate can change. There is an initial fixed-rate period during which the interest rate doesn't change - this period can range from as little as 1 month to as long as 10 years. After the initial period, the interest rate will often adjust each year. For example, with a 3/1 ARM, your interest remains the same during the first 3 years, and then can adjust every year following, up to a maximum amount (the "lifetime cap"). Indexes and margins - At the end of the initial period and at every adjustment period, the interest can change based on two factors: the "index" and the margin. Interest rate adjustments are based on a published index. There are many indexes but some commonly used for ARMs are the LIBOR and the U.S. Treasury Bill. The rates for indexes reflect current financial market conditions, which is why your interest rates can change at each adjustment period. The margin is the amount (shown as a percentage) that is added to the index to determine what your new mortgage rate will be until the next adjustment period. Caps, ceilings, and floors - All ARMs have rate caps, also known as ceilings and floors. Caps decide how much the interest rate can increase or decrease at each adjustment period and over the life of the loan. Most ARMs have a lifetime cap that limits the amount your interest rate can increase over the life of your mortgage. The number system - There are many types of ARMs. Popular ones are the 10/1, 7/1, 5/1 and 3/1. The first number (10 for example) is the length of the initial period, during which the interest rate can't change. The second number (1 for example) is how often the ARM is adjusted after the initial period. So, a 10/1 ARM won't change for the first 10 years, but can change in the 11th year and again every year after that. Depending on the initial cap the change could be as high as 5 percentage points above what it was before.
There are additional considerations to be aware of with adjustable-rate mortgages:
Because the initial interest rate is usually lower than a fixed-rate mortgage, your initial payments will be lower and you may qualify for a larger mortgage amount. If interest rates are high when you get your mortgage but drop during any adjustment period, your monthly payment may decrease. An ARM with a low initial interest rate and an initial adjustment period after 5 or 7 years can save you money. ARMs can, and often do, have interest rate increases at adjustment periods. You may have an increase in your monthly mortgage payment after each adjustment period. The amount your mortgage might increase would depend on the periodic cap (how much of an increase is allowed each year), the lifetime cap (the maximum interest rate or maximum number of increases allowed), and the size of your mortgage's margin. If the life cap is 5%, the maximum interest rate adjustment would be to 10.75%
Amortizing adjustable-rate mortgages (ARM) are the most common type of ARM. Like all ARM's, a fully amortizing ARM has an interest rate that changes periodically based on a selected rate index such as the US Treasury Bill or London Inter-Bank Offer Rate (LIBOR).
Fully amortizing ARM's usually begin with a fixed interest rate period. This fixed interest rate will typically be less than the rate offered for fixed rate loans of the same term. Monthly payments generally include principal, interest, taxes and insurance. Payments are calculated to payoff the entire mortgage balance at the end of the term. The most popular term is 30 years.
At the end of the fixed interest rate period, an adjustment to the interest rate is made based on market conditions. The adjustment may be up or down and will adjust at a fixed interval through the remainder of the loan term.
Interest Only ARM
Unlike an amortizing adjustable rate mortgage (ARM) in which monthly payments consist of both principal and interest, an Interest Only ARM requires just the monthly interest payments. Interest Only ARM's usually begin with a fixed interest rate period based on a selected rate index such as the US Treasury Bill or London Inter-Bank Offer Rate (LIBOR).An Interest Only ARM will have a period where the interest rate is fixed, and then be adjusted at pre-determined intervals thereafter. Since principal is not paid during the interest only period, monthly payments are less than for the comparable amortizing mortgage. Due to this lack of principal payment, interest only ARM's are technically balloon mortgages because a balloon payment exists at the end of the interest only period. As long as a balloon payment is not required, borrower obligations to the lender have been maintained and an option to refinance to an amortizing mortgage at market rate exists for the borrower. If exercised, the new amortizing loan may adjust up or down and will adjust at a fixed interval through the remainder of the loan term.