ARM Loans

An Adjustable Rate Mortgage, also known as an ARM, is a great option if you don't intend to stay in the home for a long period of time or you are trying to qualify for a higher loan amount.

Pro

5-to-7 year lower fixed rate translates to a lower monthly mortgage payment

Con

Considered an interest rate risk because after the 5-7 year timeframe, your interest rate can fluctuate up or down, either increasing or decreasing your monthly payments.

Also known as a variable-rate mortgage or tracker mortgage, the interest rate on the note periodically adjusts based on an index, which reflects the cost to the lender of borrowing on the credit markets. The loan may be offered at the lender's standard variable rate/base rate. There may be a direct and legally defined link to the underlying index. Since payments may increase over time there is added risk of financial hardships, so an ARM will commonly use Caps to limit risk. Most ARMs carry lifetime and periodic rate caps.

VIP Mortgage can help determine if an ARM is the right loan for you and your financial goals!

Basic ARM Features

  • Initial interest rate - This is the beginning interest rate on an ARM.
  • The adjustment period - This is the length of time that the interest rate or loan period on an ARM is scheduled to remain unchanged. The rate is reset at the end of this period, and the monthly loan payment is recalculated.
  • The index rate - Most lenders tie ARM interest rates changes to changes in an index rate. Lenders base ARM rates on a variety of indices, the most common being rates on 1-, 3-, or 5-year Treasury securities. Another common index is the national or regional average cost of funds to savings and loan associations.
  • The margin - This is the percentage points that lenders add to the index rate to determine the ARM's interest rate.
  • Interest rate caps - These are the limits on how much the interest rate or the monthly payment can be changed at the end of each adjustment period or over the life of the loan.
  • Initial discounts - These are interest rate concessions, often used as promotional aids, offered the first year or more of a loan. They reduce the interest rate below the prevailing rate (the index plus the margin).
  • Negative amortization - This means the mortgage balance is increasing. This occurs whenever the monthly mortgage payments are not large enough to pay all the interest due on the mortgage. This may be caused when the payment cap contained in the ARM is low enough such that the principal plus interest payment is greater than the payment cap.
  • Conversion - The agreement with the lender may have a clause that allows the buyer to convert the ARM to a fixed-rate mortgage at designated times.
  • Prepayment - Some agreements may require the buyer to pay special fees or penalties if the ARM is paid off early. Prepayment terms are sometimes negotiable.

Caps

Caps typically apply to three characteristics of the mortgage:

  1. Frequency of the interest rate change
  2. Periodic change in interest rate
  3. Total change in interest rate over the life of the loan, sometimes called 'Life Cap'

For example, a given ARM might have the following types of interest rate adjustment caps:

  1. Interest adjustments made every six months, typically 1% per adjustment, 2% total per year
  2. Interest adjustments made only once a year, typically 2% maximum
  3. Interest rate may adjust no more than 1% in a year

The maximum mortgage payment adjustment is usually 7.5% annually on pay-option/negative amortization loans. The total interest rate adjustment is limited to 5% or 6% for the life of the loan. Caps on the periodic change in interest rates may be broken up into separate limits; for example, 5% on the initial adjustment and 2% on subsequent adjustments. Although uncommon, a cap may limit the maximum monthly payment in absolute terms (for example, $1,000 a month), rather than in relative terms.

ARMs that allow negative amortization will typically have payment adjustments that occur less frequently than the interest-rate adjustment; for example, the interest rate may be adjusted every month while the payment is adjusted once every 12 months.

Cap structure is sometimes expressed as initial adjustment cap / subsequent adjustment cap / life cap; for example, 2/2/5 for a loan with a 2% cap on the initial adjustment, a 2% cap on subsequent adjustments, and a 5% cap on total interest-rate adjustments. When only two values are given, this indicates that the initial change cap and periodic cap are the same; for example, a 2/2/5 cap structure may sometimes be written simply 2/5.

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