Adjustable Rate Mortgage (ARM)

An ARM is a mortgage with an interest rate that may vary over the term of the loan -- usually in response to changes in the prime rate or Treasury Bill rate or the London Interbank Offering Rate Index. The purpose of the interest rate adjustment is primarily to bring the interest rate on the mortgage in line with current market rates.Mortgage holders are protected by a ceiling, or maximum interest rate, which can be reset annually. ARMs typically begin with more attractive rates than fixed rate mortgages -- compensating the borrower for the risk of future interest rate fluctuations.

Choosing an ARM is a good idea when:

  • When fixed rates have increased
  • When you are searching for the lowest possible rate

ARMs have the following distinguishing features:

  • Index
  • Margin
  • Adjustment Frequency
  • Initial Interest Rate
  • Interest Rate Caps
  • Free Interest Rate Float Down Available

An adjustable rate mortgage's interest rate increases and decreases based on publicly published indexes. ARMS are based on different indexes including:

  • United States Treasury Bills (T-bills)
  • London Interbank Offering Rate Index (LIBOR)
Margin is a fixed percentage amount that is pointed added to the index - accounting for the profit the lender makes on the loan. Margins are fixed for the term of the loan.interest rate = index + margin
Adjustment Frequency
Adjustment frequency reflects how often the interest rate changes - also known as the reset date. Most ARMs adjust yearly, but some ARMs adjust as often as once a month or as infrequently as every five years.
Initial Interest Rate
The initial interest rate is the interest rate paid until the first reset date. The initial interest rate determines your initial monthly payment, which the lender may use to qualify you for a loan. Often the initial interest rate is less than the sum of the current index plus margin so your interest rate and monthly payment will probably go up on the first reset date.
Interest Rate Caps
Interest rate caps put limits on interest rates and monthly payments.
Common caps:
Initial Adjustment Cap
An initial adjustment cap limits how much the interest rate can change at the first adjustment period.Example:If your ARM has a 1% initial adjustment cap, your interest rate may only increase or decrease by a maximum of 1% at the first adjustment period.
Periodic Adjustment Cap
A periodic adjustment cap limits how much your interest rate can change from one adjustment period to the next. Usually a six-month adjustable rate mortgage will have a one percent periodic adjustment cap while a one-year adjustable rate mortgage will have a two percent periodic adjustment cap.Example:If your loan has a 2% periodic adjustment cap, your interest rate may only increase or decrease by a maximum of 2% per adjustment period.
Lifetime Cap
A lifetime cap sets the maximum and minimum interest rate that you may be charged for the life of the loan.  Most ARMs have caps of 5% above the initial interest rate.Example:If your loan has a 5% lifetime cap, your interest rate may only increase or decrease by a maximum of 5% for the life of the loan.Initial adjustment caps, periodic adjustment caps, and lifetime caps make up an adjustable rate mortgage's cap structure, and are usually represented as three numbers. Example:2/2/5 -- Initial adjustment cap is 2 %/ periodic cap is 2% / lifetime cap is 5%.

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