Adjustable Rate Mortgages (ARM)
Adjustable Rate Mortgages (ARM) are loans that the interest rates can vary during its term. These types of loans usually have a fixed interest rate for an initial time period and then can adjust based on current market conditions. A Hybrid ARM Mortgage combine features of both fixed-rate and adjustable-rate mortgages (currently available ARMs: 5/1, 7/1, & 10/1).
What is an Adjustable Rate Mortgage (ARM)?
An Adjustable Rate Mortgage (ARM) is a type of loan where the interest rate can vary during the loan’s term:
- Have a fixed interest rate for an initial period of time and then can be adjusted based on current market conditions.
- Initial ARM rate is lower than on a fixed-rate mortgage which allows you to afford and purchase a more expensive home.
- Usually amortized over a period of 30 years with the initial rate being fixed from one month to 10 years.
- ARMs 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 is tied to i.e., 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 ARM adjusts, the margin will be added to the index and rounded to the nearest 1/8 of 1% to get the new interest rate that will be fixed for the next adjustment period which can occur every year.
- There are factors called “caps” limiting how much the rates can adjust. Example: With 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 in the 4th year would be 8.25%, and the highest you during the life of the loan would be 12.25%.
- Some ARM loans have a conversion feature to convert the loan from an adjustable-rate to a fixed-rate. There is a minimal charge to convert, however the rate is usually slightly higher than the market rate that the lender could provide at the time by refinancing.
What are Hybrid Adjustable Rate Mortgages?
Hybrid ARM Mortgages are fixed-period loans that combine features of both fixed-rate and adjustable-rate mortgages:
- Starts with an interest rate that is fixed for a period years – usually 3, 5, or 7 years. Then the loan converts to an ARM for a set number of years. Example: A 30-year Hybrid ARM with a fixed-rate for 7 years and an adjustable-rate for 23 years.
- Advantage of a fixed-period ARM is the initial interest rate of the loan is lower than the rate would be on a mortgage that’s fixed for 30 years. On the other hand, a typical 1-year ARM goes to a new rate every year, starting 12 months after the loan is taken out. While the starting rate on ARMs is lower, they carry the risk of future hikes.
- Homeowners can get a Hybrid ARM and hope to refinance as the initial term expires. Best for those who do not intend to live in their home a long time. With a lower rate and monthly payments than with a 30-year or 15-year loan, homeowners can break even faster on refinancing costs like title insurance and appraisal fees.
- Since monthly payments will be lower, borrowers can make extra payments and pay off the loan early.