Adjustable Rate Mortgage or ARM is a mortgage loan where the note will adjust periodically based on the set index. The mortgage rate is calculated at index + margin = rate.
A margin is constant throughout the life of the loan. The margin, added to the index calculates the current rate for an ARM. It is the agreed upon amount of percentage points that is added to the index.
The index is the rate set by market forces and published by a neutral third party. Indexes can be divided into two (2) broad categories: (1) those based upon rate averages, and (b) those based upon volatile spot rates.Indexes based on average rates include the 11thDistrict Cost of Funds Index (COFI) and the 12-month Moving Treasury Average (MTA) or Monthly Average Treasury (MAT).Indexes based on spot rates include: one-month London Interbank Offered Rate (LIBOR), Constant Maturity Treasury (CMT), which comes from a short-term average; other spot indexes are based on prime rate and yields on certificates of deposit (CD).
There are several important features to understand in an Adjustable Rate Mortgage loan.
- Initial Interest Rate – This is the beginning rate offered on the loan.
- Adjustment Period – This is the length of time that the initial interest rate remains unchanged. After the end of the adjustment period, the rate resets and a new monthly payment is calculated.
- Index – based on a variety of indices, most common being rates on 3, 5, 7 year Treasury securities. Some use the cost of funds of savings and loan associations’ national or regional average, etc.
- Margin – The percentage points added to the index to determine the ARM interest rate.
- Interest Rate Caps – The limits on how much interest rate or the monthly payment can change at the end of each adjustment period or over the life of the loan.
- Prepayment Penalty – A penalty imposed by the lender if the loan is paid off early or before maturity.
How ARM reset affects payment
After the initial rate ends and enters the adjustment period, the rate will adjust according to the index rate. When the rate changes, generally, the monthly payment will increase if the rates go up and decrease if the rates fall.
Most Lenders offer a “Hybrid ARM” commonly known as “Fixed Period ARM” that has an initial fixed rate period, typically 3, 5, 7 or 10 years. After the introductory fixed-rate period ends, the interest rate becomes adjustable for the remainder of the loan.
Advantages of ARM
- Allows a borrower to lower their initial monthly payment. This is suitable for those planning to move in a few years or before the end of the initial interest rate period.
- Beneficial to borrowers who are expecting an increase in their income in the near future.
- Rate savvy borrowers who believe interest rate will go down in the future.
Disadvantages of ARM
- The interest rate will increase in a rising rate environment since the index is tied to directly to rate.
- An increase in interest rate will result in higher future monthly payment.
- An increase in interest rate will reduce or prolong the accumulation of equity in the property.
Types of Hybrid ARMs
- 3/1 ARM – Interest rate is fixed for the first 3 years. After 3 years, the rate can change once every year for the remaining life of the loan.
- 5/1 ARM – Interest rate is fixed for the first 5 years. After 5 years, the rate can change once every year for the remaining life of the loan.
- 7/1 ARM – Interest rate is fixed for the first 7 years. After 7 years, the rate can change once every year for the remaining life of the loan.
- 10/1 ARM – Has a fixed interest rate for the first 10 years. After 120 years, the rate can change once every year for the remaining life of the loan.
When the rate change after the adjustment period, the monthly payment will change also. An increase in rate will result in an increase in monthly payment; a decrease in rate will result in a decrease in monthly payment.
For additional information, please contact us and schedule a one-on-one analysis and consultation.