How to Explain ARM Mortgages

An ARM loan carries a low initial interest rates, but the rate changes over time.
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Adjustable rate mortgages are more complex than fixed-rate loans. ARM loans are subject to changes throughout the repayment period. Thus, they are considered more risky because your payments increase over time. Although the low initial interest rate offered by most ARMs is tempting, ask your lender about your ARM's features and ask yourself whether its the right fit for your financial situation.

Initial Fixed-Rate Periods

One of the main benefits of an ARM is its initial, discounted interest rate, which is generally lower than that of a fixed-rate loan. The initial rate typically lasts three, five, seven or 10 years; this is known as the introductory, teaser or fixed-rate period. However, don't confuse the temporary fixed-rate of an ARM with that of the traditional fixed-rate loan, which has an established, locked-in rate that lasts the life of the loan.

ARM Adjustments and Exercises

An ARM's rate adjusts, or changes, when the initial rate expires. The ARM can also continuously adjust thereafter. For example, if your initial rate period lasts three years on a 30-year ARM, your rate is fixed for three years and may adjust annually for the remaining 27-year period. This means that if your loan adjusts each year after the first adjustment, your payment will change 28 times before the loan is paid off.

Hybrid Examples

ARMs are also known as hybrids due to their dual components:

  • the initial fixed-rate period
  • the number of years between subsequent adjustments.

Hybrids come in many variations, depending on the lender. For example, 5/1, 7/1 or 10/1 hybrids adjust after 5, 7 and 10 years, respectively, and every year thereafter. You may even find hybrids with 2-, 3- and 5-year adjustments periods. For example, a 7/2 hybrid has its first adjustment at the 7-year mark and changes every two years afterward.

Indexes, Margins and Caps

Market activity and lenders determine your ARM's index, which is just one component of your interest rate. Your lender may offer you an ARM with an index set by the London Interbank Offered Rate, or LIBOR, or the Cost of Funds Index known as the COFI. Lenders can also set their own indexes for ARMs.

Lenders add a percentage to the index, known as a margin, to come up with your interest rate. The margin varies by lender but generally remains the same throughout the life of the loan. It is often based on your credit score. The sum of the index and margin equals your fully indexed rate.

To ensure your payment doesn't exceed a certain amount, lenders may place caps on adjustments. The periodic adjustment cap limits how high or low your rate can go after the initial adjustment. The lifetime cap limits the amount it can change in total over the life of your loan.

Questions to Ask

According to the Consumer Financial Protection Bureau, you should ask your lender a series of questions to ensure you understand how your ARM works, including but not limited to:

  • How long does the initial discounted rate last?
  • What will the rate be after the discounted rate period is over?
  • How often will the rate change thereafter?
  • What is my index, margin and current rate?
  • What are the rate and payment caps?
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