Adjustable Rate Mortgage (ARM)
ARMs have an initial start rate for a specific period, after which the rate and payments may adjust yearly, either up or down. The most common loans are 3/1, 5/1, 7/1, and 10/1.
After the initial period, your rate is fixed, and your interest rate will adjust. The purpose of the adjustment is primarily to bring the interest rate on the mortgage in line with market rates—the interest rate on an adjustable-rate mortgage increases or decreases based on a published index. In addition, there is a margin associated with the rate. A pre-determined percentage is added to the index to determine the interest rate on which the payment is based.
Interest rate = index + margin
ARMs of the past had much higher margins, indexes were not as stable as those currently used, and many consumers were not educated about how they worked. Thus, ARMs got a bad reputation. But today, ARMs have interest rate caps that limit the amount the interest rate, and monthly payments can adjust on the reset dates. Borrowers should know these caps before closing on their loans and prepare for potential payment changes.
Initial adjustment cap – an initial adjustment cap limits how much the interest rate can change at the first adjustment.
Periodic adjustment cap – A periodic adjustment cap limits how much your interest rate can change from one adjustment period to the next. Usually, a six-month adjustable-rate mortgage will have a one percent periodic adjustment cap, while a one-year adjustable-rate mortgage will have a two percent periodic adjustment cap.
Lifetime cap – A lifetime cap sets the maximum and minimum interest rate you may be charged for the life of the loan. Most ARMs have caps of 5% or 6% above the initial interest rate.
ARMs provide the right borrowers with great opportunities to recognize significant savings or buy nicer homes. Be sure that you fully understand this product and your homeownership goals before choosing an adjustable-rate mortgage. The only way to know for sure is to contact a loan officer and allow them to help you explore your options.