Adjustable Rate Mortgage Basics

An adjustable rate mortgage, or ARM, is an incredible option under the right circumstances.

ARM loans made up a large number of the “toxic loans” that were at the root of the current housing crisis.  It was not the loan, but the understanding of the terms and conditions of the loan that caused most of the problem.

Using an adjustable rate mortgage is an advanced financial strategy that should not be taken lightly.  If you are attracted to an ARM simply because it offers a lower initial interest rate, you’re doing it wrong.

The single most important thing you can do to protect yourself and your family is to make purposeful financial decisions about your home mortgage financing.

Again, under the right circumstances, an adjustable rate mortgage is exactly what you might need to meet both your long term, and short term financial goals.

Adjustable Rate Mortgage

ARM loans commonly available in today’s market are fixed for a period of time, then turn adjustable after the initial fixed period.

The most common of these loan programs are 5/1 ARM, 7/1 ARM & 10/1 ARM. The first number – 5,7,10 is the fixed rate/fixed payment period of the loan.

A 5/1 is fixed for 5 years, 7/1 is fixed for 7 years, 10/1 has a fixed rate and payment for the first 10 years of the loan. The second number identifies how often the interest rate is analyzed and adjusted after the fixed rate period is over.

Most adjustable rate mortgage loans in today’s market will adjust once a year.  It is also not uncommon to find ARM loans that adjust every 6 months.

Fixed Rate & Payment Period

The Start Rate is the fixed rate period of an ARM loan.  Start rates on adjustable mortgage loans often very low and quite attractive to home buyers or homeowners trying to reduce a payment.

This start rate is often used as a “Teaser Rate” for marketing and advertising mortgage loans.  Start rates on ARM loans can be close to half that of fixed rate mortgages which make them very attractive.

Once the fixed term of the start rate is completed, the interest rate will adjust according the index and margin associated with the loan.

An ARM with a fixed period is also called an “Hybrid-ARM”.

Understanding Index and Margin

Adjustable Rate Mortgages will adjust according to the index and margin associated with that loan. The 1 Year LIBOR is an example of an index used to calculate an adjustable rate.

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The Margin is a “padding” added to the index to determine the new interest rate.  Once the fixed period is up, the margin is added to the index to determine your new interest rate.

Adjustment Caps

Adjustment caps describe the maximum adjustment an interest rate can make at each adjustment period.

Common caps are 5/2/5. This means that the initial adjustment cannot exceed 5% above or below the initial start rate, cannot change more than 2% each adjustment period after the initial period, and interest cannot exceed 5% increase or drop over the life of the loan.

Many homeowners with ARM loans that have adjusted over the last several years have seen their interest rates drop significantly due to the fact that the index tied to the rate has dropped steadily since late 2007.

To get more information about Adjustable Rate Mortgages, the Federal Reserve Board has published a Consumer Handbook on Adjustable Rate Mortgages that is required to be given to all recipients of FHA ARM loans.

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