An adjustable-rate mortgage (ARM) is a type of mortgage in which the interest rate is fixed for a period of time. How long? Well that depends on which ARM product you choose. There are plenty of options when it comes to ARM loans. The most common ones are the 10/1 ARM, 7/1 ARM and 5/1 ARM. The first of the two numbers refers to the length of the fixed period.
For example, if you choose a 10/1 ARM the initial fixed period will be 10 years. This is probably the most popular option amongst all of the ARM products. Why? Well because it’s just long enough to allow for any life changes. Relocation, refinancing, outgrown home, downsizing, etc. The benefit would be that more aggressive (lower interest rate) versus going with a traditional fixed rate. All ARM products are amortized over a 30-year period.
A variable rate mortgage is another name for an ARM, which takes a number of different forms. Floating rate mortgage is another name for one. A variable-rate mortgage, or ARM, has an interest rate reset based on a benchmark or index, plus an additional spread, called an ARM margin.
At the close of the fixed-rate period, ARM interest rates increase or decrease based on an index plus a set margin. In most cases, mortgages are tied to one of three indexes: the maturity yield on one-year Treasury bills (1YR Index), the 11th District cost of funds index, or the London Interbank Offered Rate (LIBOR).
Although the index rate can change, the margin stays the same. For example, if the index is 5% and the margin is 2%, the interest rate on the mortgage adjusts to 7%. However, if the index is at only 2% the next time the interest rate adjusts, the rate falls to 4%, based on the loan’s 2% margin. If this is still a bit confusing, please call us! We can talk all day about ARM programs.
In many cases, ARMs come with rate caps that limit how high the rate can be or how drastically the payments can change. Periodic rate caps limit how much the interest rate can change from one year to the next, while lifetime rate caps set limits on how much the interest can increase over the life of the loan. Finally, there are payment caps that stipulate how much the monthly mortgage payment can increase. Payment caps detail increases in dollars rather than based on percentage points.
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