Adjustable Rate Mortgage, often referred to as ARM, is a type of mortgage where the interest rate fluctuates periodically. These fluctuations typically occur based on an index. As the interest rates change, the mortgage payments also rise or fall accordingly. ARMs consist of various components, such as margins, indexes, discounts, negative amortization, caps on payments and rates, loan recalculations, and payment options.
When considering an ARM, it is crucial to understand the potential maximum increase in monthly payments and one’s ability to afford these higher payments in the future. The initial payments and rates of ARMs are significant factors to consider. These introductory terms remain in effect for specific durations, ranging from as short as a month to as long as over five years.
In some ARM products, the initial payments and rates can differ substantially from those that will apply later in the loan’s lifespan. Even if interest rates remain stable, payments and rates can still vary greatly. To estimate this variability, compare the annual percentage rate (APR) with the initial rate. If the APR is considerably higher than the initial rate, it’s likely that the payments and rates will increase significantly when the loan adjusts.
Most Adjustable Rate Mortgages see their monthly payments and interest rates change on a monthly, quarterly, annual, three-year, or five-year basis. The interval between these rate changes is known as the adjustment period. For instance, loans with one-year adjustment periods are referred to as one-year ARMs.
The interest rates of ARMs consist of two components: the index and the margin. The index tracks interest rates, while limits on how much the rate can increase or decrease impact your payments. Generally, as the index rises, so do your interest rates and payments. Conversely, if the index declines, your monthly payments may decrease, provided your ARM allows for downward adjustments. ARM rates can be based on various indexes, such as LIBOR (London Interbank Offered Rate), COFI (Cost of Funds Index), or a CMT (one-year constant maturity Treasury security). Some lenders utilize their own proprietary models for determining rates.
The margin is the additional premium that a lender adds to the rate. It is typically a few percentage points added directly to the index rate. Margins can vary between lenders but usually remain fixed throughout the loan term. The combination of the index plus the margin is referred to as the fully indexed rate. When a loan’s initial rate is lower than the fully indexed rate, it is called a discounted index rate. For example, if an index is at 5% and has a 3% margin added, the fully indexed rate would be 8%.
