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. The purpose of the interest rate adjustment is primarily to bring the interest rate on the mortgage in line with 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:
- Interest rates are going down
- You intend to keep your home less than 5 years
ARMs have the following distinguishing features:
- Adjustment Frequency
- Initial Interest Rate
- Interest Rate Caps
An adjustable rate mortgage’s interest rate increases and decreases based on publicly published indexes. Bank Prime Loan (Prime Rate)
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.
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.
Interest Rate Caps
Interest rate caps put limits on interest rates and monthly payments.
Negatively Amortizing Loans
Because Negatively Amortizing Loans provide payments caps instead of interest rate caps, they limit the amount the monthly payment can increase.
However, there is a risk interest rates could potentially escalate to a point where the monthly payment would not cover the interest being charged. If this scenario were to occur, the extra interest charges would be added to the principle of the loan, resulting in the borrower owing more than was initially borrowed.
Borrowers are usually allowed to make payments over the loan amount to pay down the mortgage and guard against this scenario.
Option ARM loans
Option ARM loans allow the borrower to choose the amount to pay toward the mortgage each month. Make a minimum payment, interest-only payment, 30-year amortized payment or 15-year amortized payment. Pay the minimum amount to free up funds for other uses, or make larger payments for faster equity build up.
Option Arms offer much more cash flow flexibility but must be used wisely by the borrower. Always consult a qualified loan officer to learn about all of the risks associated with these types of loans. He or she will also be able to offer valuable advice on properly managing your monthly payments.