Adjustable Rate Mortgages

An adjustable rate mortgage (ARM) is just what the name suggests. It is a loan where the interest rate changes periodically, usually in relation to an index, and payments may go up or down accordingly.

Lenders generally charge lower initial interest rates for ARMs than for fixed rate loans. This makes the ARM easier on your pocketbook at first, and also means that you may qualify for a larger loan. In addition, an ARM could be less expensive over a long period than a fixed rate loan if interest rates remain steady or move lower. Against these advantages, you have to weigh the risk than an increase in interest rates would lead to higher monthly mortgage payments in the future.

The Basic ARM Features

Initial Interest Rate

This is the interest rate on the loan until the first adjustment occurs. On a 1 Year ARM, the initial interest rate is for 1 year. On a 3 Year ARM, the initial interest rate is for 3 years.

The Adjustment Period

With every ARM the interest can change sometime during the life of the loan. The period between one rate change to the next is called the adjustment period.

The adjustment period is the feature that is used to distinguish one type of ARM from another. For example, an ARM with an adjustment period of one year means that the interest rate can change once every year, and is called a "one year ARM". (See "Types of ARMs" below).

Index

The index of an ARM is the financial instrument that the loan is "tied" to, or adjusted to. The index will usually go up and down with the general movement of interest rates. If the index rate moves up so does your mortgage rate in most instances, and you probably have to pay a higher monthly payment. And if the index goes down, your monthly payment may go down.

The most common indices, or, indexes are the rates on one, three, and five year Treasury Securities. Other common indexes are LIBOR (London Interbank Offered Rate), the Prime rate, 6-Month Certificate of Deposit (CD) and the 11th District Cost of Funds (COFI). A few lenders use their own cost of funds as an index, which, unlike other indexes, they have some control.

You should always ask what index will be used, how often it changes, how has it fluctuated in the past, and where it is published.

Margin

The margin is added to the index to determine the interest rate that you pay. The margin added to the index is known as the fully indexed rate. As an example if the current index value is 5.50% and your loan has a margin of 2.5%, your fully indexed rate is 8.00%.

Periodic Interest Rate Caps

A periodic interest rate cap limits the interest rate change from one adjustment period to the next. Interest rate caps are beneficial in rising interest rate markets, but can also keep your interest rate higher than the fully indexed rate if rates are falling rapidly.

Lifetime Interest Rate Cap

By law, almost all ARMs must have a lifetime interest rate cap. (also know as an overall cap). A lifetime interest rate cap is the maximum interest rate that the ARM may have. Some lifetime caps are a set percentage rate, and some lifetime caps are a percentage over the initial interest rate.

Payment Caps

Some ARMs have payment caps, usually instead of periodic interest rate caps. A payment cap limits your monthly payment increase at the time of each adjustment, usually to a percentage of the previous payment. If the ARM has a payment cap, be sure to find out if the loan has the possibility of negative amortization.

Conversion Feature

Some ARMs carry a conversion feature, which allows you to convert your loan to a fixed rate loan at designated times in the future. These are called Convertible ARMs.

Types of ARMs

As previously mentioned, the adjustment period is the feature that is used to distinguish one ARM from another. The following are the most common types of ARMs:

6 Month ARM: Interest rate adjusts every 6 months.

1 Year ARM: Interest rate adjusts every year.

3 Year ARM: Interest rate adjusts every 3 years.

5 Year ARM: Interest rate adjusts every 5 years.

3/1 ARM: Interest rate is fixed for first 3 years, then adjusts every year thereafter.

5/1 ARM: Interest rate is fixed for first 5 years, then adjusts every year thereafter.

2/28 ARM: Interest rate is fixed for first 2 years, then adjusts once and is fixed for the remaining 28 years of the loan.

ARMs with the more frequent adjustments generally carry a lower initial interest rate. For example, the initial interest rate on a 6-Month ARM would be lower than the initial interest rate on a 5-Year ARM. Of course the trade off is that a 6-Month ARM is subject to more frequent interest rate and payment changes.

Should You Utilize An ARM?

Fixed rate mortgages are still the most popular and common type of mortgage loan. However, for some consumers, an ARM makes good financial sense. The following are some important things to consider when deciding between a fixed rate and an ARM:

The importance of fixed vs. adjusting payments. Can your personal budget afford payment changes? Borrowers whose income is rising may tolerate ARM programs better than someone on a fixed income.

How long will you keep the loan? If you plan to payoff the loan in a short period of time, considering an ARM with a lower starting interest rate.

Possibility of significant interest rate changes. Will changes in interest rate and payments threaten your ability to make the loan payments?