Understanding Adjustable Rate Mortgages (ARMs)
Adjustable Rate Mortgages (ARMs) have interest rates that can change during the loan’s term. These loans usually start with a fixed interest rate for an initial period, then adjust based on current market conditions. Because of this, the initial rate on an ARM is lower than that of a fixed-rate mortgage, enabling you to afford and purchase a more expensive home.
How ARMs Work
ARMs typically amortize over 30 years. The initial rate remains fixed for a period ranging from 1 month to 10 years. An ARM loan combines a “margin” and an “index.” Margins usually range from 1.75% to 3.5%, depending on the index and the amount financed relative to the property’s value. The index is a financial instrument to which the ARM loan is tied, such as:
- 1-Year Treasury Security
- LIBOR (London Interbank Offered Rate)
- Prime Rate
- 6-Month Certificate of Deposit (CD)
- 11th District Cost of Funds (COFI)
Rate Adjustments
When the ARM adjusts, the margin adds to the index, typically rounding to the nearest 1/8 of one percent, to determine the new interest rate. This rate then fixes for the next adjustment period, which usually occurs annually. However, caps limit how much the rates can adjust. Caps provide some protection against drastic rate hikes.
Example Scenario
Consider a “3/1 ARM” with an initial cap of 2%, a lifetime cap of 6%, and an initial interest rate of 6.25%. For the first three years, the interest rate remains fixed at 6.25%. In the fourth year, the rate can increase by a maximum of 2%, making it 8.25%. Over the life of the loan, the highest possible rate is 12.25%.
Summary
ARMs offer a lower initial interest rate compared to fixed-rate mortgages. This can make it easier to afford a more expensive home. The rates adjust based on market conditions and are influenced by margins and indices. Caps limit the amount the rate can increase, providing some protection. Understanding how ARMs work can help you decide if this type of mortgage suits your financial situation.