Adjustable Rate Mortgages (ARM)

As just mentioned, the adjustable part of the loan applies to the interest rate charged the borrower. The rate of interest charged usually moves in step with a well-known indicator of inflation. The terms and conditions of the loan will state the exact index used, the most common of which include:

• National Average Contract Mortgage Rate

• Constant Maturity Treasury or CMT

• Treasury Average Index (12 month TCM)

• 11th District Cost of Funds Index or COFI

• London Interbank Offered Rate or LIBOR

• Prime Lending Rate (plus)

When the prime lending rate is used, the index is usually based on prime plus a margin basis. This means the interest rate charged will carry a premium (be higher) when compared to the actual prime interest rate.

In most instances, the terms of an adjustable rate mortgage will also include two "caps" or maximum allowable adjustments to the interest rate of the loan. The most common caps apply to:

• The overall rate of interest charged, sometimes referred to as the lifetime cap

• The amount by which the interest rate can be adjusted in any one period

This concept of these moving interest rates is best explained using an illustration.

Adjustment Cap Example

In this example, the ARM's terms and conditions are for a $100,000 mortgage, with an initial interest rate of 5.50%, a 12.00% lifetime cap, and a 1.00% cap on adjustments.

What this means is the interest rate on the loan can never exceed 12.00%. In addition, the rate of interest charged after the first adjustment cannot exceed 6.50%, or 5.50% + 1.00%.

Adjustable rate mortgages will also indicate the allowable frequency of change to interest rates. Here again, the terms of the ARM will usually specify two variables with respect to this change:

• The timeline until the first allowed change in rate, sometimes referred to as the resetting date

• The time until subsequent allowable changes

Again, the best way to explain this concept is by using an example.

Rate Change Example

Critical ARM Terms and Conditions:
- Limits: total allowable interest rate change and/ or how much the rate can change during each adjustment
- Frequency: first adjustment to interest rates, then timeframe until subsequent adjustments

Moneyzine Editor

At this point, we're going to expand on the previous example. But this time we're going to explain further that this mortgage started in the year 2020 and it was a 5 Year ARM with a 12-month subsequent adjustment period. In this example, the first adjustment to interest rates cannot occur before the year 2025; the resetting date. However, every twelve months after 2025, the lender is allowed to make additional adjustments.

When adjustable rate loans are quoted in the newspaper, or online, they're stated in a way that provides information on the frequency of change as well as the interest rates. For example, a 3/1 ARM indicates three years until the first adjustment, and one year for each subsequent adjustment. A 5/1 ARM allows the borrower to repay the loan for five years until the adjustments begin.

In today's mortgage marketplace, there are two additional variations that are worth mentioning: the hybrid and the option ARM. As a new homeowner it's important to understand the terms and conditions of an option ARM because this type of loan can actually result in what's called a negative amortization. Simply put, the loan can grow over time, not decrease.

Hybrid Adjustable Rate Mortgages

A true adjustable rate mortgage is a loan where the interest rate adjusts on a consistent and predetermined basis. For example, a one-year ARM adjusts each year. Hybrid ARMs are quite common and the example used earlier is actually a Hybrid. The term refers to the fact the loan is at a fixed rate of interest for a period of time, and then floats later on. For example, a 5/1 ARM is a hybrid that carries a fixed rate of interest for the first five years, then a floating rate of interest afterwards.

Option Adjustable Rate Mortgages

An option ARM is a loan that allows the borrower to choose how they would like to make a payment each month. Option ARMs can include three or more "options" or choices:

• A predetermined minimum payment

• An interest-only payment

• A fixed rate of interest payment

Option ARMs are often marketed with an extremely low rate of interest to lure consumers to the loan. The minimum payment feature found on this type of mortgage results in negative amortization. This means the outstanding loan amount, or principal, is increasing over time rather than decreasing.

Perhaps the biggest benefit of an ARM is the low rate of interest these loans typically carry. This rate is really just a reflection of the risk of rising interest rates being shifted from the bank, mortgage company, or lender, to the borrower. Since the borrower now bears the risk of rising interest rates, the loan can be initially written at a lower rate. Another big benefit of ARMs applies to those homeowners that do not anticipate living in a home for a long period of time. It is not unusual for employees to be assigned to certain geographies for five years or less. In addition, the first time home buyer may purchase a "starter" house knowing they are not going to live there for more than three to five years. In both of these examples, the homeowner is planning to sell the home before the adjustment period / resetting date begins. In this situation, they reap the benefit of lower interest rates, and the risk of an adjustment is minimized, or eliminated.

The biggest down side of ARMs is that they can give the homeowner a false sense of security about their family's financial health. Individuals might buy homes and stretch themselves financially by taking out a loan they can barely afford in the hope they will be able to find additional income before the ARM starts adjusting. This is, in fact, a very real danger that exists with this type of mortgage. When thinking about choosing an ARM, do it for the right reason. Don't be fooled into thinking a new job will appear and the household's income is going to rise dramatically. Work with the lender, and they'll outline the maximum monthly mortgage payment possible with each loan type being evaluated.