Adjustable Rate Mortgages (ARMs)
Adjustable Rate Mortgages (ARMs)
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 an index such as the Treasury Bill rate or the London Interbank Offering Rate (LIBOR). The purpose of the interest rate adjustment is primarily to bring the interest rate on the mortgage in line with current market rates.
Mortgage holders are protected by a ceiling, or maximum interest rate, that 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 adjustable rate mortgage is usually a good idea when:
- Interest rates are going down
- You intend to keep your home less than 5 years
adjustable rate mortgages have the following distinguishing features:
- An index
- A margin
- Adjustment Frequency
- Initial Interest Rate
- Interest Rate Caps
- Convertibility
Index: An adjustable rate mortgage's interest rate increases and decreases based on publicly published indexes. Adjustable rate mortgages are typically based on one of following indexes:
- United States Treasury Bills (T-bills)
- London Interbank Offering Rate Index (LIBOR)
- The 11th District Cost of Funds Index (COFI)
- Certificate of Deposit Indexes (CODI)
- Cost of Savings Index (COSI)
- 12-Month Treasury Average (MTA or MAT)
- Bank Prime Loan (Prime Rate)
Margin: A margin is a fixed percentage amount that is added to the index, and accounts for the profit the lender makes on the loan. Margins are fixed for the term of the loan.
- Interest Rate = Index + Margin
Adjustment Frequency: Sometimes known as the reset date, the adjustment frequency is how often the interest rate on the adjustable rate mortgage changes. 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 the interest rate that is paid until the first reset date. The initial interest rate determines your initial monthly payment which the lender may use to qualify you for a 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 most likely increase on the first reset date.
Interest Rate Caps: Interest rate caps put limits on interest rates and monthly payments. Common interest rate caps include:
- Initial Adjustment Cap - An initial adjustment cap limits how much the interest rate can change at the first adjustment period.
Example:
If your ARM has a 1% initial adjustment cap, your interest rate may only increase or decrease by a maximum of 1% at the first adjustment period.
- 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 1% periodic adjustment cap, while a one-year adjustable rate mortgage will have a 2% 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.
- Lifetime Cap - A lifetime cap sets the minimum and maximum interest rate that you may be charged over the life of the loan. Most ARMs have caps of 5% or 6% above the initial interest rate.
Example:
If your loan has a 6% lifetime cap, your interest rate may increase or decrease only by a maximum of 6% 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:
Example:
1/2/6 -- The initial adjustment cap is 1% / the periodic cap is 2% / the lifetime cap is 6%.
Option ARMs (Sometime referred to as Pick-A-Payment loans or Negatively Amortizing (Neg Am) Loans)
Option ARM loans allow the borrower to choose the amount to pay towards the mortgage each month. With an Option ARM loan, you can make a minimum payment, an interest-only payment, a 30-year amortized payment or a 15-year amortized payment. You can also make any payment that is more than the interest only payment.
You can pay the minimum amount to free up funds for other uses, or make larger payments to build up equity quickly. Option ARMs offer much more cash flow flexibility than any other mortgage plan, but must be used wisely by the borrower. Always consult a qualified loan officer to learn about all of the risks associated with these types of loans. He or she will also be able to offer valuable advice on properly managing your monthly payments.
Because Option ARMs 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 principal of the loan, resulting in the borrower owing more than was initially borrowed. This is known as negative amortization. Borrowers are usually allowed to make payments over the minimum loan payment 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. It's also useful for those who own their own business or are in sales and have fluctuating monthly incomes. However, this should only be used as a short-term solution.
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