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Adjustable Rate Mortgage
An adjustable rate mortgage (ARM) is a loan that has a variable interest rate. Hybrid ARM loans carry a fixed interest rate for a predetermined period and will convert to an index (usually treasury bill) plus margin (a predetermined rate) once the fixed period is over. The margin will vary based on a number of factors such as credit score, LTV, property type and etc. As far as the index is concerned, the lender has total control over the decision of selecting the index.
The more common adjustable rate mortgage loans are 3/1 (rate is fixed for the first 3 years), 5/1 (rate is fixed for the first 5 years), 7/1 (rate is fixed for the first 7 years) and 10/1 (rate is fixed for the first 10 years) usually amortized over a 30 year period. An adjustable loan may be an interest only loan. Which basically means you only have to pay interest on the balance of the loan for the fixed period vs. principle and interest on a traditional loan.
Common terms important to understanding adjustable rate loans and calculating potential future costs:
- Initial interest rate, This is the beginning interest rate on an ARM.
- Adjustment period, is the length of time that the interest rate or loan period on an ARM is scheduled to remain unchanged. The rate is reset at the end of this period and the monthly loan payment is recalculated.
- Index rate, is a published financial index rate such as LIBOR.
- Interest rate cap, is the limit on how much the interest rate can be changed at the end of each adjustment period or over the life of the loan.
- X/Y, Hybrid ARMs are often referred to in this format, where X is the number of years during which the initial interest rate applies prior to first adjustment (common terms are 3, 5, 7, and 10 years), and Y is the interval between adjustments (common terms are 1 for one year and 6 for six months). As an example, a 5/1 ARM means that the initial interest rate applies for five years (or 60 months, in terms of payments), after which the interest rate is adjusted annually. (Adjustments for escrow accounts, however, do not follow the 5/1 schedule; they are done annually.)
- Fully Indexed Rate, The actual interest rate of an ARM. Index + Margin = Fully Indexed Rate.
Margin, For ARMs where the index is applied to the interest rate of the note on an “index plus margin” basis, the margin is the difference between the note rate and the index. The lower the margin the better the loan.
- Index, A published financial index such as the treasury bills used to periodically adjust the interest rate of the ARM.
- Start Rate, The introductory rate provided to purchasers of ARM loans for the initial fixed interest period.
- Payment Shock, Industry term to describe the increase in monthly mortgage payments. Generally caused by changing interest rates.
- Cap, Any clause that sets a limitation on the amount or frequency of rate changes.