Basically, there are three types of ARMs – Hybrid, Interest-Only and Option ARMs. However, there may be several other variants that manifest features of an adjustable-rate mortgage.
The Three Basic Types
A hybrid type allows you to enjoy a fixed-rate period before the rate begins to adjust. Most adjustable-rate mortgages available today are of this type, which you see in a number of variations, such as 3/1, 5/1 and 7/1 ARMs. A 3/1 ARM simply means that the first adjustment will be after 3 years and then the rate will be adjusted annually. Mortgages are available with 3, 5, 7, 10 and 15 years of initial fixed period.
In an interest-only payment plan, you have to pay only interest for an initial period of 3 to 10 years. Remember your principal balance doesn’t decrease for as long as you pay the interest portion only. However, your monthly payments become much lower and quite affordable if you are not earning much. Also note that the longer the I-O period the higher your monthly payments will be when you begin to pay for the principal component as well.
You are offered a range of payment options under a payment-option ARM, which is also referred to names like option/flexible payment/1 month option/12 MTA pay option ARM. Your options may include a minimum payment, a 15-year fully amortizing payment, a 30-year fully amortizing payment and a 40-year fully amortizing payment, besides interest-only option. A minimum payment option can lead to a situation called negative amortization (which is when you owe more than the original loan amount). You may also be required to make a balloon payment at the end of the loan term.
Other Variants of ARMs
This is a much affordable type of adjustable-rate mortgage on which the initial rate is 3.95%.
Lenders enjoy full control in respect to the change in interest rate. The rate can be changed at any time on advance notice. Such kinds of adjustable-rate mortgages are found outside the United States.
All adjustable-rate mortgages in the U.S are indexed ARMs. This mortgage is so called because the rate adjusts automatically based on the changes in an interest rate index, such as COFI or LIBOR.
Two Step Mortgage
A two step mortgage allows you to have one interest rate for the first five to seven years and then a different rate (either fixed or variable) for the remainder of the term.
Secure option ARM
A secured option ARM has a minimum payment option that is based on a teaser rate. After the expiration of this rate, the mortgage has a fixed-interest-rate period and behaves like a hybrid ARM.
With a convertible ARM, a borrower may choose to convert to a fixed-rate mortgage within a stipulated time.