An Adjustable Rate Mortgage (ARM) is a mortgage with an interest rate that may vary over the term of the loan — usually in response to changes in a universally-recognized published rate (LIBOR, T-Bill, prime, etc). The purpose of the interest rate adjustment is primarily to bring the interest rate on the mortgage in line with market rates.
Mortgage holders are protected by a ceiling, or maximum interest rate, which can be reset annually. ARMs typically begin with more attractive rates than fixed rate mortgages — compensating the borrower for the risk of future interest rate fluctuations.
Choosing an ARM is a good idea when You intend to keep your home less than the initial fixed rate term (for example: you get a 5-year ARM because you plan to sell the house within 5 years).
ARMs have the following distinguishing features:
- Adjustment Frequency
- Initial Interest Rate
- Interest Rate Caps
An adjustable rate mortgage’s interest rate increases and decreases based on publicly published indexes. ARMS are based on different indexes including:
- United States Treasury Bills (T-bills)
- The 11th District Cost of Funds Index (COFI)
- London Interbank Offering Rate Index (LIBOR)
- Certificate of Deposit Indexes (CODI)
- 12-Month Treasury Average (MTA or MAT)
- Cost of Savings Index (COSI)
- Bank Prime Loan (Prime Rate)
Margin is a fixed percentage amount that is added to the index – accounting for the profit the lender makes on the loan. Margins are fixed for the term of the loan.
floating interest rate = index + margin
Adjustment frequency reflects how often the interest rate changes – also known as the reset date. Most ARMs adjust yearly, but some ARMs adjust as often as once a month or as infrequently as every five years.
Initial Interest Rate
The initial interest rate is a feature of "hybrid" ARMs (which is what most people think of when they hear the term "ARM loan") in which the interest rate remains constant until the first reset date. The initial interest rate determines your initial monthly payment, but the lender may use a higher rate to qualify you for the loan. Often the initial interest rate is less than the sum of the current index plus margin so your interest rate and monthly payment will probably, but not always, go up on the first reset date. Standard ARMs do not have an initial interest rate – the rate is always index plus margin from day 1.
Interest Rate Caps
Interest rate caps put limits on interest rates and monthly payments:
- An initial adjustment cap limits how much the interest rate can change at the first adjustment period.
Example: If your ARM has a 5% initial adjustment cap, your interest rate may only increase or decrease by a maximum of 5% at the first adjustment period.
- 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.
Example: If your loan has a 2% periodic adjustment cap, your interest rate may only increase or decrease by a maximum of 2% per adjustment period.
- A lifetime cap sets the maximum and minimum interest rate that you may be charged for the life of the loan. Most ARMs have caps of 5% or 6% above the initial interest rate.
Example: If your loan has a 5% lifetime cap, your interest rate may only increase or decrease by a maximum of 5% for the life of the loan.
Initial adjustment caps, periodic adjustment caps, and lifetime caps make up an adjustable rate mortgage’s cap structure, and are usually represented as three numbers.
So let’s say you are looking at a 7/1 ARM at 4.00% with 5/2/5 caps. This means that this program is an ARM loan with an initial rate of 4.00% that lasts for 7 years. After that, the rate adjusts every 1 year. The initial adjustment cap is 5%, the periodic cap is 2%, and the lifetime cap is 5%.
Negatively Amortizing Loans
Because Negatively Amortizing Loans (a.k.a "Neg-Am Loans") provide payments caps instead of interest rate caps, they limit the amount the monthly payment can increase. However, there is a risk interest rates could potentially escalate to a point where the monthly payment would not cover the interest being charged. If this scenario were to occur, the extra interest charges would be added to the principle of the loan, resulting in the borrower owing more than was initially borrowed. Borrowers are usually allowed to make payments over the loan amount to pay down the mortgage and guard against this scenario.
There are certain times when having a negatively amortizing mortgage could be beneficial. If a borrower were to lose a job or have an unexpected financial emergency a negative amortization option could ease cash flow situation. However, this should only be used as a short-term solution.
Option ARM loans
Option ARM loans allow the borrower to choose the amount to pay toward the mortgage each month. Make a minimum payment, interest-only payment, 30-year amortized payment or 15-year amortized payment. Pay the minimum amount to free up funds for other uses, or make larger payments for faster equity build up. Option Arms offer much more cash flow flexibility but must be used wisely by the borrower.
Neg-Am Loans and Option ARM Loans were hotly debated back in 2007-2008 as many experts cited them as a main reason for the mortgage meltdown. But regardless of what you may think of them, both of these types of loans are a thing of the past.