Adjustable Rate Mortgages

Adjustable-Rate Mortgages (ARMs) feature interest rates that change over the life of the loan. Typically, ARMs begin with a lower fixed interest rate for an initial period before adjusting based on current market conditions. This lower initial rate can make ARMs an appealing option for purchasing a more expensive home.

Adjustable-Rate Mortgages (ARMs): What You Need to Know

How Adjustable-Rate Mortgages Work

ARMs are typically amortized over 30 years and start with a fixed interest rate for an initial period, which can range from 1 month to 10 years. The interest rate on an ARM is determined by combining two components: the margin and the index.

• Margin: A fixed percentage (usually 1.75% to 3.5%) added to the index.

• Index: A financial benchmark, 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)

The combination of the margin and index determines the adjustable rate.

Understanding Rate Adjustment

When the fixed-rate period ends, the ARM adjusts based on the margin and the current value of the index, rounded to the nearest 1/8 of one percent. Adjustments typically occur annually, and rate caps limit how much the rate can increase:

• Initial Cap: Limits the rate increase after the fixed period.

• Periodic Cap: Limits how much the rate can adjust at each adjustment period.

• Lifetime Cap: Sets the maximum rate increase over the loan’s term.

Consider a 3/1 ARM with the following terms:

• Initial rate: 6.25%

• Initial cap: 2%

• Lifetime cap: 6%

For the first three years, the interest rate remains fixed at 6.25%. In the fourth year, the rate can increase by up to 2%, making it 8.25%. Over the loan's lifetime, the maximum rate would be 12.25%.

Adjustable-Rate Mortgages offer lower initial interest rates compared to fixed-rate mortgages, making them an attractive option for those looking to afford a more expensive property. However, the rates adjust based on market conditions, influenced by margins and indices, with caps providing some protection against significant increases. Understanding the structure and potential risks of ARMs can help you decide if this loan type aligns with your financial goals.

ARM in Action: A Detailed Example

Key Points to Remember