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Adjustable Rate Mortgages
Adjustable Rate Mortgages (ARMs)
In contrast to a Fixed Rate Mortgage an Adjustable Rate Mortgage (ARM) has an interest rate that changes throughout the life of the loan. This is referred to as the "adjustment." The amount of time until the interest rate changes is known as the adjustment period and can occur every month, quarter, year, 3 years or 5 years depending on what was stated within the mortgage terms.
The interest rate on an Adjustable Rate Mortgage is calculated by using an index and a margin. An index is a general way to measure current rates. Popular indexes used by most lenders and brokers include the 1-year Constant Maturity Treasury Securities (CMT), Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). The margin is what the lender or broker adds on top to make a profit on the mortgage. Easily put, the better the credit score of the borrower the lower the margin. These two entities put together make up the interest rate of an Adjustable Rate Mortgage. While the margin remains the same throughout the life of the mortgage, the index will change and, consequently, change the interest rate. If the index drops the interest rate usually follows suit. The same applies if the index rate rises. Chances are great that the mortgage's interest rate (and the payment) will rise at the beginning of the next adjustment period.
Interest Rate Caps are also a good thing to be aware of when considering an adjustable rate mortgage. These include Periodic Adjustment Caps, Lifetime Caps and Payment Caps. A Periodic Adjustment Cap limits the amount an interest rate can adjust between periods. This is a good tool to mitigate any problems associated with highly volatile payments. If, for some reason, an index takes a huge swing a Periodic Adjustment Cap will help absorb that shock over time instead of all at once. A Lifetime Cap limits the amount the interest rate can adjust for the entire life of the loan. This allows the borrower to be aware of the absolute highest mortgage payment possible. A Payment Cap helps to limit the amount a payment can increase between periods. Like the Periodic Adjustment Cap it helps to absorb the shock of rapidly increasing interest rates.
Types of ARMs
Fixed Period ARMs - A Fixed Period ARM has a typical term of 15, 30 or 40 years. The only difference from a Traditional Fixed Rate Mortgage is that the interest rate can change throughout the life of the loan.
Interest Only Arms - This type of ARM allows the borrower to make interest only payments for a set number of years (usually 3-10) then begin paying on the principal. When the principal payments are due the mortgage payment rises. This occurs even if the interest rate doesn't increase because nothing has been paid towards the principal.
Minimum Payment ARMs - A Minimum Payment ARM is just as its name states: a mortgage that has a minimum payment. With this type of mortgage it's not uncommon to have a payment that is less than the interest due for that period. This creates a negative amortization (the leftover interest due is added onto the principal). If only the minimum payment is made the total amount of the mortgage will be more than it was to begin with due to the negative amortization.
Hybrid ARMs - A Hybrid ARM is a mortgage that is fixed for a certain period then becomes an Adjustable Rate Mortgage. This is usually expressed as a ratio that includes the number of years the mortgage is fixed over the adjustment period (in years). For example, a Hybrid ARM with the terms 3/1 would mean that the mortgage is fixed for three years and after that the rate will adjust once every year for the remainder of the loan period.
Option ARMs - This type of mortgage allows the borrower to decide from several predetermined options how they would like to pay each payment period. This usually includes an amount that would pay off some of the principal, an interest only amount and a minimum payment (that negatively amortizes).
Important things to think about when considering an Adjustable Rate Mortgage are the index and margin, how the interest rate will be calculated, how often the interest rate changes (the adjustment period), limits on interest rate changes (caps), negative amortization (if any) and a few examples of what your mortgage payment might look like in given situations.