An adjustable-rate mortgage (ARM) has a variable interest rate that may change monthly payments many times during the life of the loan. Unlike discretionary ARMs, which allow rate changes at the lender’s discretion, the indexed ARMs are linked to an interest rate index, giving a lender very limited control on rate changes. All adjustable-rate mortgages in the U.S. are indexed ARMs.
Basic Features of ARMs – The Four Components
An index rate is used to adjust the ARM interest rate periodically. The changes in an index rate are unpredictable and nobody can tell when it will go up or down. To make the interest rate less volatile, a lender may adjust it on the average value of an index over time. It is important to ask your lender how the interest rate be adjusted and what index will be used. Some indices include COFI, LIBOR, MTA and CMT.
A margin refers to the number of percentage points that a lender adds to the index rate for the calculation of ARM interest rate at each adjustment. The margin generally ranges from 2 to 3 percentage points and varies from one lender to another. As an example, a 4% index and a 3% margin will add up to make a fully indexed rate of 7%.
To limit the risk associated with an adjustable-rate mortgage, there exist interest rate caps as well as payment adjustable caps.
A cap is placed on the maximum an interest rate can increase within a given time. Depending on the period during which it is valid, there can be initial rate cap, periodic (annual or semiannual) cap and lifetime cap (or life cap). Interest-rate caps limit the amount your payments can increase in an adjustment period and over the life of the loan.
A cap can also be placed on the ARM payment to keep it within a specified limit. The payment adjustment cap protects a borrower from too much increase in monthly payments even with the increase in interest rate.
Rate adjustment is what makes an ARM unique. You need to understand two things – the initial rate and the rate adjustment period.
Initial Interest Rate and Payment
This is the starting interest rate, which is typical with a hybrid ARM. Also known as the teaser rate, it lets you enjoy low monthly payments during the initial few years of the loan (which may range from 1 month to 10 years). Note that the initial rate usually adjusts up at the next adjustment period, because it is lower than the sum of index and margin, which is the usual ARM rate. The initial interest rate is fixed throughout the initial rate period.
The interest rate begins to adjust frequently after the initial rate period expires. Note that the initial rate period and the adjustment period need not be the same. For example, a 3/1 ARM has an initial rate period of 3 years after which the rate adjusts every year.