An Adjustable Rate Mortgage is a mortgage where the interest rate can change over the term of the loan — usually in response to changes in the prime rate or LIBOR (London InterBank Offered Rate). The purpose of the interest rate adjustment is to bring the interest rate on the mortgage in line with market rates. Adjustments occur according to a predetermined adjustment schedule.
ARMs typically start off with lower interest rates than fixed rate mortgages, which compensate the borrower for the risk of the interest rate increasing over time. You are protected by “caps” which set a ceiling for the 1st adjustment, periodic adjustments, as well as the total amount of adjustments allowed over the life of your loan.
Choosing an ARM is a good idea when:
- Interest rates are going down. This is because you stand a chance of keeping the same rate later when your loan reaches the adjustment period.
- You only plan on keeping your home less than 5 years.
- ARMs have the following distinguishing features:
- Index (this is the index that your ARM is assigned to, which could be the LIBOR, T-Bill, Prime or COFI)
- Margin (The margin is used in calculating your new interest rate when it comes time for your rate to adjust)
- Adjustment Frequency (this is how often your rate adjusts after the fixed period)
- Initial Interest Rate (this is what your start rate is, before you reach the adjustment period)
- Interest Rate Caps (this is how much your loan could go up at each change once past your fixed period)
- Interest Only ARMs
Index is a fixed percentage amount which accounts for the profit a lender makes on the loan.
Margins are fixed for the term of the loan and are added to the index in order to determine what the rate may possibly move to at each adjustment period.
Interest Rate = Index + Margin
Adjustment frequency reflects how often the interest rate changes – also known as the reset date. Most ARMs adjust yearly; however, some ARMs adjust as often as once per month or as infrequently as every five years.
The Initial Interest Rate is the interest rate 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. The initial fixed-rate period can be as short as once per month, or as long as 10 years. One-year ARMs, which have their first adjustment after one year, used to be the most popular adjustable, and were the benchmark. Recently the standard has become the 5/1 ARM, which has an initial fixed-rate period that lasts five years; the rate is adjusted annually thereafter. That type of mortgage, which mixes a lengthy fixed period with an even lengthier adjustable period, is known as a hybrid.
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 go up on the first reset date. Other popular hybrid ARMs are the 3/1, the 7/1 and the 10/1.
These hybrid ARMs — sometimes referred to as 3/1, 5/1, 7/1 or 10/1 loans — have fixed rates for the first 3, 5, 7 or 10 years, followed by rates that adjust annually thereafter.
After the fixed-rate honeymoon, an ARM’s rate fluctuates at the same rate as an index spelled out in closing documents. The lender finds out what the index value is, adds a margin to that figure, and recalculates the borrower’s new rate and payment. The process repeats each time an adjustment date rolls around.
Interest Rate Caps
Borrowers have some protection from extreme changes because ARMs come with caps. These caps limit the amount by which ARM rates and payments can adjust.
Caps come in a couple of different forms. The most common are:
- Periodic rate cap: Limits how much the rate can change at any one time. These are usually annual caps, or caps that prevent the rate from raising more than a certain number of percentage points in any given year.
- Lifetime cap: Limits how much the interest rate can rise over the life of the loan.
- Payment cap: Offered on some ARMs. It limits the amount the monthly payment can raise over the life of the loan in dollars, rather than how much the rate can change in percentage points.
Interest-only ARMs Around the turn of the 21st century, lenders began to market interest-only mortgages to middle-class borrowers. Formerly the preserve of what lenders called “affluent clients,” interest-only mortgages are usually adjustable. The borrower is required to pay only the interest for a specified period, often 10 years. After that, it adjusts to the going interest rate, as tracked by a specified index. After that, the loan amortizes at an accelerated rate. During the interest-only period, the borrower can choose to pay some principal, too. By providing flexibility in the size of monthly payments, interest-only mortgages often are a good match for people with fluctuating monthly incomes: for example, salespeople who are paid by commission.
Conversion Some ARMs come with a conversion feature that allows borrowers to convert their loans to fixed-rate mortgages for a fee. Others allow borrowers to make interest-only payments for a portion of their loan terms to keep their payments low. However, no matter the exact terms, most ARMs are more difficult to understand than fixed-rate loans.
To keep your financial options open, make sure to ask the mortgage lender if the ARM is convertible to a fixed-rate mortgage. Also, ask if the ARM is assumable, which means when you sell your home the buyer may qualify to assume your existing mortgage. That could be desirable if mortgage interest rates are high.
Most ARM rates are tied to the performance of one of three major indexes:
- Weekly constant maturity yield on the one-year Treasury Bill. The yield debt securities issued by the U.S. Treasury are paying, as tracked by the Federal Reserve Board.
- 11th District Cost of Funds Index (COFI). The interest financial institutions in the Western U.S. are paying on deposits they hold.
- London Interbank Offered Rate (LIBOR). The rate most international banks are charging each other on large loans.
For more information please call Raleigh’s Local Loan Experts at 919-866-0212 to answer any questions you may have!