Adjustable Rate Mortgages (ARM) loans usually have a fixed interest rate for an initial period of time, after which they can be adjusted 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 between 1 month and 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 1% 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 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.
Hybrid ARM mortgages, also called fixed-period ARMs, combine features of both fixed-rate and adjustable rate mortgages. A hybrid loan starts out with an interest rate that is fixed for a period of years (usually 3, 5, 7 or 10). Then, the loan converts to an ARM for a set number of years. An example would be a 30-year hybrid with a fixed rate for 7 years and an adjustable rate for 23 years.
The beauty of a fixed-period ARM is that the initial interest rate for the fixed period of the loan is lower than the rate would be on a mortgage that’s fixed for the full term, sometimes significantly. Hence you can enjoy a lower rate while having a stability period for your payments. A typical one-year ARM, on the other hand, goes to a new rate every year, starting 12 months after the loan is taken out. So while the starting rate on ARMs is considerably lower than on a standard mortgage, they carry the risk of future hikes.
Homeowners can get a hybrid and hope for favorable refinancing as the initial term expires. These types of loans are best for people who do not intend to keep their homes. By getting a lower initial rate and lower monthly payments than with a 30- or 15-year loan, they can break even more quickly on refinancing costs, such as title insurance and the appraisal fees. Since the monthly payments will be lower, borrowers can make extra contributions and pay off the loan early, saving thousands during the years they have the loan.
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