What is an Adjustable Rate Mortgage?An Adjustable Rate Mortgage (ARM) is a mortgage in which the interest rate is adjusted periodically based on a pre-selected index.
Characteristics of an ARM
Index – An index is a published interest rate against which lenders measure the difference between the current interest rate on an adjustable rate mortgage and that earned by other investments (ex. 5 year U. S. Treasury yields, 6 month LIBOR, and the 11th District cost-of-funds index, or COFI). The index is then used to adjust the interest rate up or down.
Margin – The margin is the percentage a lender adds to the index to establish the adjusted interest rate.
Adjustment Date – The adjustment date is the date that the interest rate changes.
Adjustment Interval – The adjustment interval is the time between changes in the interest rate and monthly mortgage payment.
Interest Rate Caps – Interest rate caps are consumer safeguards that limit the amount of change to the interest rate. Caps assure the borrower that financing costs will not rise excessively if there is a sharp increase in interest rates.
Start Rate (also know as initial interest rate) – The start rate is the interest rate of the mortgage at the time of closing. This rate will change at the adjustment intervals based on the index, margin, caps, and floor rate.
Floor Rate – The floor rate is the minimum rate that the mortgage could ever achieve regardless of the caps. The floor protects the lender from a sharp decrease in rates.
For the following definitions we will use the adjustable rate mortgage example below:
5/1 ARM with caps of 5/2/5
This ARM will have a start rate that will be fixed for the first five years of the loan term (5/1 ARM with caps of 5/2/5). The 1 (5/1 ARM with caps of 5/2/5) means that it will adjust once per year (see adjustment interval definition above) after the initial fixed period.
Initial Interest Rate Cap (5/1 ARM with caps of 5/2/5) - The maximum percentage that an interest rate can change during the first adjustment. In the example above, the interest rate can increase or decrease a maximum of 5% in the first adjustment, subject to the floor rate (see floor rate definition above).
Periodic Interest Rate Caps (5/1 ARM with caps of 5/2/5) – The maximum percentage that an interest rate can change during each adjustment after the first. In the example above, the interest rate can increase or decrease a maximum of 2% for each adjustment after the first, subject to the floor rate.
Lifetime Interest Rate Caps (5/1 ARM with caps of 5/2/5) – The maximum percentage that an interest rate can change during the life of the loan. In the example above, the interest rate can increase or decrease a maximum of 5% throughout the entire life of the loan, subject to the floor rate.
When is an Adjustable Rate Mortgage a Good Idea?
An ARM is not for everybody. However, in certain cases choosing an ARM over a fixed rate mortgage can save the borrower thousands of dollars in interest charges. For borrowers who feel they will own their home for a relatively short period of time, an ARM can be a perfect solution. Many ARMs come with a fixed period of 3, 5, 7, or 10 years. If the borrower will be living in the home for less than any of these terms, they will not be subject to any rate adjustements. Therefore, by choosing an ARM, they will typically save on interest payments due to the fact that ARMs typically come with lower interest rates than FRMs. It might also make sense to choose an ARM when economic conditions indicate that interest rates will be decreasing in the future. This can be a risky strategy and it is best to discuss this with your loan officer prior to making a final decision.
Check out the resources on http://www.noblelenders.com/ to learn more about financing options.
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