An Adjustable Rate Mortgage (ARM) is a type of loan that comes with a variable interest rate. Most ARMs that are available nowadays come with a fixed interest rate for an initial period of time, typically 3, 5, 7, or 10 years. By opting for an ARM, you are essentially taking on some of the risk associated with potential increases in interest rates, which is why the initial interest rate on an ARM is generally lower compared to a fixed rate mortgage. Additionally, the length of the initial fixed period usually determines the initial rate, with shorter fixed periods resulting in lower rates. The terms of an ARM are determined by its initial fixed term, adjustment period, margin, index, and caps (and potentially a floor). To determine when and how often the interest rate can change, you need to consider the initial fixed term and adjustment period. These timelines are usually presented with a slash between them, such as “7/1” or “5/6”. For instance, a 7/1 ARM is a loan with an initial fixed term of 7 years that then adjusts on an annual basis. On the other hand, a 5/6 ARM has a fixed period of 5 years before it adjusts every 6 months. It’s a bit inconsistent, but that’s how it works.
After the initial fixed period, your rate will begin to adjust. The margin, typically around 2.25%, 2.5%, or 2.75%, remains constant and is preferentially lower. The index, a market-driven benchmark interest rate, is tied to your loan rate. The lender adds the margin to the index when adjusting your interest rate, resulting in a new rate known as the “fully indexed rate”. Most loans round to the nearest .125%. To prevent extreme changes, caps are imposed on ARMs. Caps are written as “2/6” or “5/2/5”. The initial cap limits the maximum change during the first adjustment, while the lifetime cap sets the overall limit for rate increases. If there is a middle number, it represents the maximum change at any adjustment besides the initial one.
Discover the significance of capitalization as you delve into the world of ARMs. In addition to the margin and index, some ARMs come with a floor, which sets the absolute minimum interest rate regardless of calculations. When discussing an ARM, we will furnish you with a disclosure specific to the program and thoroughly explain the terms. Deciding if an ARM is right for you involves peering into the future. Consider the duration of the loan and anticipate how your income and expenses may change over time. The key is to strike a balance between the risk of higher rates in the future and the advantage of a lower initial rate, while also planning for worst-case scenarios. It is crucial to understand your own comfort level. Even if an ARM appears ideal on paper, will you be able to sleep soundly knowing that your rate can fluctuate? Here’s an interesting tidbit about ARMs: every time your interest rate adjusts, your loan is re-amortized. This makes an ARM an intriguing option if you plan on regularly making extra payments towards your principal, such as annual gifts from family or yearly bonuses.