Adjustable Rate Mortgage

Adjustable Rate Mortgage or ARM is also known as adjustable rate loan, variable rate loan, variable rate mortgage and floating rate mortgage. Adjustable Rate Mortgages became more popular in 2004, when the Federal Reserve began raising the Fed Funds rate. This made adjustable-rate mortgages more profitable compared to fixed rate mortgages, whose rates are tied to the 10-year Treasury Bond.

I simple language ARM, is a kind of mortgage whose interest rate changes or varies as per specific criteria. The initial interest rate is normally fixed for a period of time, after which it is changed periodically, often every month. ARM is associated with figures such as 1/10, 1/7, 2/28/, 3/27, etc.



The first figure in each set refers to the initial period of the loan, during which your interest rate will stay the same as it was on the day you signed your loan papers.
The second number is the adjustment period, showing how often adjustments can be made to the rate after the initial period has ended. The interest rate paid by the borrower will be based on a benchmark plus an additional spread, called an ARM margin.
Like in 2/28 mortgage's initial interest rate is fixed for 2 years and then changes to a floating rate for the remaining 28 years of the mortgage. Whereas, in 3/27 mortgage, the interest rate is fixed for 3 years and then floats for the remaining 27 years of the mortgage.

Examples:

1. The initial interest rate is 4.5%, the index is 7%, and the margin is 3%,
then the new interest rate = 7% + 3% = 10%.
If the lifetime cap is 5% then
the actual new interest rate will be 4.5% + 5% = 9.5%.

2. The initial interest rate is 6%, the index is 5%, and the margin is 3%,
then the new interest rate = 5% + 3% = 8%.
If the periodic cap is 1% then
the actual new interest rate will be 6% + 1% = 7%.


Types of ARMs

1 Year ARM with 2/6 Caps

The annual percentage rate for this loan is fixed for the initial term of 1 year. After that time, the annual percentage rate may change once a year. The annual percentage rate adjustment cap is plus or minus 2%. The lifetime annual percentage rate cap cannot go up or down more than 6% from the original rate.

3 to 1 ARM

This loan has a fixed rate for the initial term of 3 years. Followed by, the annual percentage rate change of only once a year. The annual percentage rate adjustment cap is plus or minus 2%. The lifetime annual percentage rate cap cannot go up or down more than 6% from the original rate.

5 to 1 ARM

The annual percentage rate for this loan is fixed for a period of five years. After this time, the annual percentage rate may change each year, but is limited to a 2% increase or decrease. The cap for the life of the loan is limited to 5%, plus or minus, of the original rate.



7 to 1 ARM

With a fixed rate for the first seven years, this loan's annual percentage rate may change once a year. The annual percentage rate may adjust no more than 5% at the end of the first adjustment period of seven years. Thereafter, the annual percentage rate adjustment cap is plus or minus 2%. The lifetime annual percentage rate cap cannot adjust up or down more than 5% from the original rate.

10 to 1 ARM

The annual percentage rate of this loan is fixed for a period of ten years. After this time, the annual percentage rate may change each year. The first rate adjustment is limited to 5% of the original interest rate with subsequent rate adjustments limited to 2%, plus or minus. The lifetime cap of the loan is 5% of the original interest rate.

With most ARMs, the interest rate can adjust every month, every three or six months, once a year, every three years, or every five years. The interest rate on negatively amortized loans can adjust monthly. A loan with an adjustment period of 6 months is called a 6-month ARM, with an adjustment period of 1 year is called a 1-year ARM, and so on.

ARMs offer an initial lower interest rate than the fully indexed rate (index plus margin) during the initial period of the loan, which could be one month or a year or more. It is also known as teaser rate.

Advantages of ARM Loan:

1) The biggest advantages that the ARM loan offers are the lower initial interest rate. This lower interest rate will also give you a much lower monthly payment that can either save you money or allow you to buy a bigger house then you could with a fixed rate mortgage.

2) It provides a stability in the sense that you always know what your payment will be.

3) You can choose from 15-year mortgages, and then at various intervals, all the way now up to 50 year mortgages.

4) The fixed rate portion of the loan allows you to enjoy a fixed rate for that period of time that you choose. This can be really good if the economy is doing well and the rates are low.

5) Depending on your contract, your adjustments are made on either a monthly or yearly basis, giving you maximum flexibility.

Disadvantages Of ARM Loan:

1) That dark side is in the form of an interest rate that can sky rocket quickly leaving you with a mortgage payment that can be hard to pay every month.

2) Due to high interest rate your credit score or property values may decrease and you may stuck in a mortgage that’s hard to pay and impossible to refinance out of.


In either case, there are pros and cons - all depending on the economy. The good thing is that there is always the possibility of refinancing - if need be. Be sure to compare any offers you receive in order to determine the best buy for your situation. Get several offers from different companies in order to see the possibilities, and you may want to get some advice from outside sources as to whether a fixed rate or adjustable rate is the best for you.