How ARM Loans Work
Mortgage can be divided into two broad categories: fixed-rate or adjustable-rate loans. A fixed-rate mortgage has the same interest rate for the entire term of the loan, while the interest rate of an adjustable-rate mortgage, or ARM, resets at periodic intervals. ARMs are more complicated than fixed-rate loans, and homebuyers should understand all of the terms before accepting an ARM.
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Why an ARM?
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Homebuyers choose an ARM over a fixed-rate loan for the lower initial interest rate and monthly payment. The rates for fixed-rate loans are based on long-term interest rates. Adjustable-rate loans are calculated from short-term rates, which are usually lower than long-term rates. For example, in February 2011, HSH.com reported 30-year fixed-rate mortgages at 5.33 percent and one-year ARM loans at 3.81 percent.
Rate Calculation
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The interest rate for an ARM is set in the loan contract and calculated by adding a margin rate to the selected interest rate index. Often-used rate indexes are the one-year Constant Maturity Treasury, or CMT; the London Interbank Rate, or LIBOR; and the 11th District Cost of Funds Index, or COFI. These indexes reflect current short-term interest rates. The margin amount in an ARM is typically 2 to 3 percent, and this rate is added to the index rate when it is time to reset the adjustable-rate mortgage.
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Rate Resets and Payments
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The initial rate and payment for an ARM is usually for one year. Hybrid ARMs have the initial rate fixed for 5 or 7 years and are referred to as 5/1 or 7/1 ARM loans. After the initial rate period, an ARM will reset once a year. The new rate is calculated using the index and margin rates. The payment for the next year is determined from the new rate, the current loan balance and the term remaining in the loan. The rate and payment each year for an ARM can go up or down.
Caps and Limits
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ARM contracts have interest rate caps and lifetime limits for how much the rate can increase. For example, an ARM may have an annual cap of a 2 percent rate increase with a term of loan limit of 6 percent. If the index rate increases significantly during the year, the reset interest rate would be limited to 2 percent higher than the previous year's rate. For homebuyers, it is a good idea to have the lender calculate the payment amount if the mortgage hits the interest rate cap in the first few years.
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