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Adjustable Rate Mortgage "ARM"

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What Is An Adjustable Rate Mortgage Or "ARM"

  • Adjustable rate loans, as the name implies, has an interest rate that can change throughout the life of the loan. Borrowers select an adjustable rate mortgage program due to the lower starting rates on these loan types. Adjustable rate mortgages, or ARMs have rates that can adjust once per year. An ARM can also be in the form of a hybrid where the initial interest rate is fixed for a predetermined period before adjusting once per year. Most adjustable rate mortgages today come in the form of hybrid loans which have initial fixed terms of 3, 5, 7 and 10 years. These loans are written as 3/1, 5/1, 7/1.

Key Benefits Of An Adjustable Rate Mortgage Or ARM

  • An ARM has a lower start rate than a fixed rate mortgage
  • An ARM can increase your home purchasing power due to the lower rate
  • This is an ideal loan program for a short term buyer
  • You can start with a lower rate of an ARM and refinance into a conventional loan later

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How Does An ARM Work?

  • An adjustable rate mortgage is based upon a financial index, a margin and specific caps that are written into the loan. Once the initial fixed term is ending, the borrower will be made aware of what the new rate will be for the coming year. A common financial index today that lenders use is the Constant Maturity Treasure, or CMT. A common CMT today is the One-Year CMT. When a hybrid loan is about to adjust, an additional margin is typically added to the index. A common margin is 2.00%.

    For example, If we add the margin of 2.00% to the 1-Year CMT , which lets say is 1.50%, the new interest rate for the following year is then will be 3.50%. One year later, the index will be referred to again and the 2.00% margin is added for the index rate at that time.

  • ARMs also have interest rate caps. A cap was put in place for the consumers protection. The "cap" will limit how much a rate may change upon adjustment. There is an initial cap that limits how much the rate can be after the hybrid period has elapsed. An annual cap that limits how much the rate can change from year to year and a lifetime cap that limits how much the rate can change over the life of the loan. Different adjustable rate programs can have different caps.

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Frequently Asked Questions

Most frequent questions and answers

Can I refinance an ARM later on if I decide to own the property longer and get a fixed rate?

Yes you can refinance out of an adjustable rate mortgage and into a fixed rate loan at any time.

Are closing costs higher with an ARM?

No. Closing costs are the same if the loan is an ARM or if it is fixed.

What makes an adjustable rate change?​

An ARM interest rate fluctuation is due to the rate being linked to a common index, such as Libor (The London Interbank Offered Rate) or the US Monthly treasury average. Offered rate or the US Monthly Treasury Average (MTA).  If economic conditions cause the index to move up, your interest rate will generally increase which means that your monthly payments will be higher  On the other hand, if the index goes down, your monthly payment will typically go down.   

How do I know when my rate will adjust?

To know when or how often your interest rate and payment on an ARM can adjust,  you need to look at the name of the loan product. For example, a one year ARM can adjust the interest rate once a year. A 3 year arm can change the rate once every 3 years.

What is a periodic adjustment cap?

This is where the interest rate is fixed for the first few years and then the interest rate may adjust on a periodic basis. For example, a 5/1 ARM is a loan that is fixed for 5 years and then adjusts every year until the loan is paid off.

What is a margin?

The margin is a set number of percentage points that a lender adds to the index rate. For instance, if the index is currently 2% and the margin is 2%, then the fully indexed rate you pay is 4%. And if the index rises to 3%, the additional margin of 2% makes the full rate 5%.

Some lenders base the amount of margin they charge on an ARM on your credit. The better your credit score the lower the margin, and the less you have to pay for the mortgage. So when comparing ARMs always look at both the index and the margin percentages.

What is a hybrid arm?

This is where the interest rate is fixed for the first few years and then the interest rate may adjust on a periodic basis. For example, a 5/1 ARM is a loan that is fixed for 5 years and then adjusts every year until the loan is paid off. 

What is a negative amortization?

.When you don’t cover the amount of interest owed each month, you get into a dangerous situation known as negative amortization. With negative amortization your unpaid interest gets added to your mortgage balance, so instead of paying down your loan, you end up oweing more than you originally borrowed. 

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