What is an Adjustable Rate Mortgage (ARM)?
An adjustable rate mortgage (ARM) is a mortgage whose rate changes at some pre-determined interval. The interest rate will be based on the combination of an index and margin. The index is the current market rate such as US Treasury Bill, Prime Rate or London Inter-Bank Offer Rate (LIBOR). The margin is a premium added to the index by an investor such as a bank. Together, the index and margin comprise the interest rate quoted to the borrower. The index may vary up or down from one adjustment interval to another. The margin will remain the same for the life of the mortgage. Somewhere in the fine print will also be a term called mortgage floor. The floor is a rate the loan mortgage never fall below. There will also a term called cap. There will typically be two caps; an adjustment cap and a lifetime cap. The adjustment cap is the maximum amount the interest rate may adjust at any adjustment interval. The lifetime cap is a maximum interest rate rate the mortgage can never exceed regardless of adjustments.
If staying in the same home for 30 years is not in your plans, an adjustable-rate mortgage (ARM) may be right for you. An ARM generally offers a lower initial interest rate than a fixed-rate mortgage. With lower monthly payments in the initial years of your mortgage, you may qualify for a larger ARM mortgage than you could with a comparable fixed rate morgage.
If one or more of these situations describes you, an ARM might be a good fit:
- You plan to stay in your home for a relatively short period of time
- You're a first-time homeowner looking to move up, yet unsure of how long you'll stay in your new home
- You want lower initial monthly payments and can handle potential payment increases in the future
- You want to qualify for a larger mortgage amount, and you expect your income to go up over time
- You are a new construction customer looking for an extended lock
Adjustable Rate Mortgage Features
- You can select an ARM with a fixed-rate period of up to 10 years. The interest rate and your monthly payment stay the same during the fixed-rate period.
- After that, the interest rate adjusts (usually annually) based on a specific financial index -- for example, one frequently used index is tied to the price of U.S. Treasury bills or securities. Another popular index is the London Inter bank Offer Rate (LIBOR).
- In addition to the index, an additional percentage, known as a "margin" may be added to the index value to determine your interest rate at the time of adjustment.
- The rate moves up or down, depending on how interest rates have moved since you took out your loan. This means that when interest rates go up, your monthly mortgage payments may go up as well. On the other hand, when interest rates go down, your monthly mortgage payments may also go down. ARMs typically have an interest rate cap (or maximum) on the periodic adjustments and for the life of the loan. So, you know that your monthly payment can never increase above a certain amount.
- ARM's fall into two main categories; amortizing and interest only. With an amortizing ARM, each payment includes principle and interest. With an interest only ARM, just interest payments are made during the interest only period.