Adjustable Rate Mortgages (ARM)

Adjustable Rate Mortgages (ARM)

Adjustable Rate mortgages (ARMs), as the name suggests, are ‘adjusted’ i.e. the interest rate is reset at certain intervals say 12 months etc. based on a pre-determined formula or approach at the closure of the loan. ARMs have grown in popularity over the last few years, and more people are using ARMs to increase their affordability or qualify for larger loans given their lower initial interest rates.

How an ARM works:

• Lenders initially offer a low interest rate called as a teaser rate. It is fixed for a certain period of time say 6 months or 5 years for a 5/1 ARM.
• At the end of the period, the rate adjusts based on an index. All ARMs are tied to a certain economic index or a publicly available market yield. Some common indexes are average rate paid on jumbo CDs, one-year, three-year Treasury notes and bills etc. The rates on these indexes are well publicized and you should understand the type of index being used in your ARM and their current rates.
• The lenders add a margin or rate increment above the index to determine your rate i.e. your rate = index + margin ( such a rate is referred to as ‘fully indexed rate’)
• The interest on the ARM and consequently your payments will be adjusted at the adjustment interval stated in your loan documents. For example if you have a 3/1 ARM, the first adjustment will occur at the end of 3 years or 36 months from the anniversary of the loan and then subsequently every year for the remainder of the loan.

Your rate is driven by or influenced by the following:

• Index: As noted above, your rate = index + margin, thus as the index rate changes so will the interest rate for that period.
• Period adjustment caps: A period adjustment cap limits how much interest rates can adjust during a certain period. For e.g. if a period cap is 2%, your interest rate cannot increase by more than 2% beyond your previous rate as long as it is lower than the lifetime adjustment cap.
• Lifetime adjustment cap: Lifetime cap is the maximum interest rate that can be levied during the life of the loan.
• Adjustment intervals: For a 5/1 ARM, the initial interest rate or teaser rate is fixed for the first 5 years of the loan. Greater the ‘fixed’ period, larger is the interest rate.

Advantages of an ARM

• It may be easier to qualify for an ARM loan given the lower initial payments.
• If you do not plan to stay in your house for a long time, then ARMs will generally result in lower interest expenses as compared FRMs over your period of stay.
• If you anticipate that your income or savings will increase over time, but currently you cannot afford higher payments, an ARM may better suit your budget.

Disadvantages of an ARM

• In an environment of rising interest rates, you are exposed to the risk of higher payments.
• If your initial payment does not cover the interest due, it will result in negative amortization. In such a situation, the unpaid interest is added to the principle. The calculator provided at anawise.com does not model for negative amortization, but be aware of the movements of your index rate and ask your lender how he handles negative amortization.
• Varying payments may make it difficult to budget for and administer.