These types of mortgages can be divided into two main categories: (1) Standard Payment ARMs and (2) Multiple Payment Option ARMs ("Option ARMs").
Standard Payment ARMs
These mortgages have a rate for a set period of time which could be anywhere from one month to ten years. Typically, the lower the start rate is the shorter the period of time before the first adjustment takes place. After an initial term, the interest rate on an adjustable-rate mortgage is re-set periodically at specified intervals (i.e. every year). For example, a 3/1 ARM offers a fixed rate for the first three years, adjusting once a year thereafter. A 5/1 ARM offers a fixed rate for the first five years, adjusting yearly thereafter.
The changing market conditions during the adjustment period will dictate whether the interest rate will increase or decrease. If interest rates go up, your monthly mortgage payment will go up. However, if interest rates go down, your mortgage payment will go down.
Some things you will need to consider in determining which ARM is the right choice for you are the index, the margin, and the adjustment caps. When it is time for the ARM to adjust, the lender sets the new interest rate by adding an adjustable index to a fixed margin. Adjustment caps control how much the rate can adjust (up or down) during each adjustment period and over the life of the loan.
Index - The index of an ARM is the financial instrument that the loan is "tied" to, or adjusted to. The most common indices are LIBOR (London Interbank Offered Rate), 11th District Cost of Funds (COFI), 1 Year Constant Maturity Treasury Rate (CMT), 12 Month Treasury Average (12 MTA), and Prime. Each of these indices moves up or down based on conditions of the financial markets. ***For more information about indices click here.
Margin - The margin is one of the most important aspects of ARMs because it is added to the index to determine the interest rate that you pay. The margin added to the index is known as the fully indexed rate. For example, if the current index value is 4.50% and your loan has a margin of 2.75%, your fully indexed rate is 7.25%. Over the life of the loan, the interest rate can never be lower than the margin; this is sometimes referred to as the “floor rate.”
Adjustment Caps – These usually comes in the form of initial adjustment, subsequent adjustment, and lifetime adjustment. For example, an ARM with a 5/2/5 rate cap means the initial rate adjustment cannot be increased or decreased above or below the loan’s initial interest rate more than 5%. At each subsequent adjustment, the interest rate cannot be increased or decreased above or below the loan’s interest rate for the preceding adjustment period by more than 2%. The maximum rate payable over the life of the loan is the loan’s initial interest rate plus 5%. This is an illustration of a 5/2/5 rate cap, but there are different variations depending on the other terms of the ARM.
Multiple Payment Option Mortgages (“Option ARMs”)
These loans offer the borrower the flexibility of choosing among multiple payment options every single month. The start rate is typically extremely low – sometimes as low as 1.00%.
The borrower is given the option every month to make a payment based on this low “payment rate.” The payment rate, which is often referred to as the “minimum payment,” will remain constant for the first twelve months. Then it will adjust slightly and be fixed for an additional twelve months before it adjusts slightly once again and so on - typically for the first five years.
At the same time, the actual interest rate on the loan is adjusting on a monthly basis. As a result, the borrower will be given the option each month of making either the minimum payment or an interest only payment based on note rate in a given month unless the note rate results in a payment that is lower than the minimum payment. In these cases, the excess payment will be applied to reduce the outstanding principal balance.
In the event the minimum payment is not sufficient to cover the interest only payment, the difference will be applied to increase the outstanding principal balance (i.e. deferred interest or negative amortization). These loans usually have a third option of making a fully amortized payment based on the fully indexed rate for that given month.
These loans are an extremely popular choice among investors who intend to keep a property for a very short period of time and do not care about the potential for negative amortization since they are counting on the property appreciating at an even faster rate.
Please use the resources available on this website to help you make an informed decision and if you have any questions along the way make sure to use the “Ask An Expert” feature.
