Adjustable Rate Mortgages (ARM)
Adjustable Rate Mortgages (ARM)'s are loans whose interest rate can vary during
the loan's term. These loans usually have a fixed interest rate for an initial
period of time and then can adjust based on current market conditions. The initial
rate on an ARM is lower than on a fixed rate mortgage which allows you to afford
and hence purchase a more expensive home. Adjustable rate mortgages are usually
amortized over a period of 30 years with the initial rate being fixed for anywhere
from 1 month to 10 years. All ARM loans have a "margin" plus an "index." Margins
on loans range from 1.75% to 3.5% depending on the index and the amount financed
in relation to the property value. The index is the financial instrument that
the ARM loan is tied to such as: 1-Year Treasury Security, LIBOR (London Interbank
Offered Rate), Prime, 6-Month Certificate of Deposit (CD) and the 11th District
Cost of Funds (COFI).
When the time comes for the ARM to adjust, the margin will be added to the
index and typically rounded to the nearest 1/8 of one percent to arrive at the
new interest rate. That rate will then be fixed for the next adjustment period.
This adjustment can occur every year, but there are factors limiting how much
the rates can adjust. These factors are called "caps". Suppose you had a "3/1
ARM" with an initial cap of 2%, a lifetime cap of 6%, and initial interest rate
of 6.25%. The highest rate you could have in the fourth year would be 8.25%,
and the highest rate you could have during the life of the loan would be 12.25%.
Some ARM loans have a conversion feature that would allow you to convert the
loan from an adjustable rate to a fixed rate. There is a minimal charge to convert;
however, the conversion rate is usually slightly higher than the market rate
that the lender could provide you at that time by refinancing.