An adjustable rate mortgage (ARM) is a great option if you want to take advantage of the historically low mortgage rates. All ARMs have an interest rate and monthly principal that stay the same during the initial period. After this initial period ends, the interest rate begins to adjust at set time periods explained below. As a general rule, it is best to get an ARM when interest rates are expected to fall so that you pay less interest over time.
Reasons to Consider an ARM
- if you plan to own your home for only a few years
- if you expect an increase in your earnings in the future
- if the current interest rate for a fixed rate mortgage is too high
Advantages of an ARM
- The initial interest rate of an ARM is lower than a fixed interest rate mortgage
- Flexible interest rates with various timeframes (ex. 1-year ARM or a hybrid ARM)
- You may qualify for a higher loan amount
- The more frequent the interest rate adjusts through the life of the loan, the lower the initial rate.
There are four main components to an ARM. The first is an index. The index is the financial instrument that the ARM loan is tied to, such as LIBOR or COFI. As the index figure moves up or down, your interest rate adjusts accordingly.
Second, there is a margin. Unlike the index which moves up and down over the life of the loan, the margin is a constant throughout the life of the loan and will not change. The margin may range from 1.75% to 3.5% depending on the index and the amount financed in relation to the property value. When it’s time for the ARM to adjust, the margin is added to the index and rounded to the nearest 1/8 of one percent to arrive at the new interest rate. The interest rate is then fixed for the next adjustment period. This adjustment can occur every year for example.
Third, there is an interest rate cap. The interest rate cap protects you from large interest rate swings. There are two types of caps: annual and life-of-the-loan. The annual cap limits or “caps” the amount your interest rate can change in any given year, while the life-of-the-loan cap limits the maximum and minimum interest rate you may pay for the entirety of the loan term.
Lastly, there is an initial interest rate period. When the initial interest rate period expires, the new interest rate is calculated by adding the margin to an index.
To avoid an increase in interest rates altogether, you would need to refinance or close the loan by selling before the interest rate adjusts. There is also an option to convert the loan from an ARM to a fixed rate.
Types of ARMs
1-year ARM: The rate changes every 12 months. This can be risky because your payment can change significantly year to year.
3-year ARM: The rate changes every 3 years.
5-year ARM: The rate changes every 5 years.
3/1 ARM: The interest rate is fixed for the first 3 years and turns into a 1 year ARM for the remaining loan term.
5/1 ARM: The interest rate is fixed for the first 5 years and turns into a 1 year ARM for the remaining loan term.
7/1 ARM: The interest rate is fixed for the first 7 years and turns into a 1 year ARM for the remaining loan term.
10/1 ARM: The interest rate is fixed for the first 10 years and turns into a 1 year ARM for the remaining loan term.
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