Adjustable Rate Mortgage (ARM)
An Adjustable Rate Mortgage (ARM) is a mortgage where the interest rate can fluctuate over the life of the loan. It typically fluctuates in response to changes in federal funds or Treasury bill rates. The main purpose of interest rate adjustments is to adjust mortgage interest rates to market rates.
Mortgage owners are protected by a cap or maximum interest rate that can be reset annually. ARMs typically start at more attractive interest rates than fixed-rate mortgages. It compensates the borrower for the risk of future interest rate fluctuations.
An Adjustable Rate Mortgage is a good choice if:
- Interest rates are falling
- If you plan to own the house for less than five years
ARM loans have the following distinctive features:
- Adjustment frequency
- Initial interest rate
- Interest rate ceiling
Interest rates on variable-rate mortgages fluctuate based on published indices. ARMS are based on various metrics such as:
- Secured Overnight Financing Rate (SOFR)
- US Treasury Bills (T-Bills)
- District 11 Financial Cost Index (COFI)
- London Interbank Offering Rate Index (LIBOR)
- Certificate of Deposit Index (CODI)
- 12 Month Treasury Average (MTA or MAT)
- Cost of Savings Index (COSI)
- Bank prime loan (prime rate)
Margin is a fixed percentage added to the index that takes into account the profit a lender makes on a loan. The margin is set over the life of the loan.
Interest Rate = Index Margin
Adjustment frequency reflects how often interest rates change and is also known as the adjustment date. Most Adjustable Rate Mortgage loans reconcile annually, but some reconcile once a month or every five years.
Initial interest rate
The first interest rate is paid up to the first reset date. The initial interest rate determines the initial monthly payment that the lender can use to qualify for the loan. Initial interest rates are often lower than the sum of the current index and margin.
Interest rate cap
An interest rate cap puts an upper limit on interest rates and monthly payments.
Initial adjustment cap
The initial adjustment cap limits how much the interest rate can change during the first adjustment period.
If the ARM's initial adjustment cap is 1%, the interest rate may only increase or decrease by a maximum of 1% during the first adjustment period.
Periodic adjustment cap
The Periodic Adjustment Cap limits the range of interest rate fluctuations from one adjustment period to the next. Typically, 6-month variable rate mortgages have a 1% cap on periodic adjustments, and 1-year mortgages have a 2% cap on periodic adjustments.
If your loan has a periodic adjustment cap of 2%, the interest rate can only increase or decrease by a maximum of 2% per adjustment period.
A lifetime cap sets the maximum and minimum interest rate that can be charged over the life of the loan. Most ARMs have caps that are 5% or 6% higher than the original interest rate.
If the loan maturity cap is 6%, the interest rate can increase or decrease by up to 6% over the life of the loan.
The Initial Adjustment Cap, Periodic Adjustment Cap, and Lifetime Cap make up the ceiling structure of a variable rate mortgage and are usually represented by three numbers:
1/2/6 - Initial Adjustment Cap is 1% / Periodic Cap is 2% / Lifetime Cap is 6%.
Negative amortization loan
Negative amortization loans provide a payment cap, not an interest cap, thus limiting the amount your monthly payments can increase. However, there is a risk that interest rates will rise and your monthly payment may not cover the interest you are charged. When this scenario occurs, additional interest costs are added to the principal of the loan, leaving the borrower with more debt than they originally borrowed. Borrowers are usually allowed to make payments in excess of the payment amount to pay down the mortgage and prevent this scenario.
Negative amortization mortgages can be beneficial. A negative amortization option can ease cash flow situations if a borrower loses their job or encounters unexpected financial hardship. However, use this only as a short-term solution.
Option ARM loans
Option ARM loans allow the borrower to choose the monthly mortgage payment amount. Make minimum payments, interest-only payments, 30-year amortization, or 15-year amortization payments. Pay a minimum to free up your money for other uses, or pay more to build your equity faster. Option ARMs offer great liquidity flexibility, but should be used with caution by borrowers. Always discuss all risks associated with these types of loans with a qualified loan officer. He or she can also provide valuable advice on how to properly manage your monthly payments.