How to Explain ARM Mortgages

The interest rate on an adjustable rate mortgage (ARM) fluctuates with changes in the market rate. ARM advantages include an introductory period where the interest rate is lower than most interest rates; and if market rates fall, you can take advantage of the lower rates without having to refinance. However, adjustable rate mortgages are dangerous because the rate can increase, and the mortgage payment may rise suddenly and unexpectedly. If you cannot make the payment, your lender may foreclose on your home.

Instructions

1. Determine the introductory interest rate period. The introductory period has a fixed interest rate that is typically lower than it will be for the rest of the loan. For example, on a 5/1 ARM, the introductory rate will be fixed for the first five years while a 7/2 ARM will keep the introductory rate for the first seven years.

2. Calculate how often the interest rate adjusts after the introductory period ends. Each ARM has a set period of time between rate adjustments. For example, a 5/1 ARM would adjust on an annual basis, after the introductory period, while a 7/2 ARM would adjust every two years after the introductory period.

3. Explain how the new interest rate is determined when the interest rate is adjusted. The ARM is tied to an interest rate index, such as the London Interbank Offered Rate (LIBOR), then a margin is added to the index rate. For example, if the margin is 2 percent and the LIBOR rate is 5.45 percent when the interest rate is scheduled to adjust, the new interest rate would be 7.45 percent.

4. Clarify that the monthly payment of the ARM can change over the life of the loan, unlike fixed rate mortgages. When the interest rate changes, the loan is re-amortized, and the monthly payment is recalculated.

5. Discuss the caps, if any, on the ARM mortgage. Caps can limit the amount the interest rate can change per adjustment or over the life of the loan. For example, if an ARM has a 0.5 percent adjustment cap, the interest rate of the mortgage cannot increase or decrease more than 0.5 percent each time it changes. If the prior rate was 6.6 percent, it cannot increase to more than 7.1 percent or decrease below 6.1 percent.

References

• Bank Rate: Understanding Adjustable Rate Mortgages
• Federal Reserve: Consumer Handbook on Adjustable Rate Mortgages