What is an adjustable-rate mortgage (ARM)? The interest rate for ARMs varies with time. Usually, the lender will adjust the interest rate every six or twelve months, but might shorten the period. After the specific time period, your interest rate would change and your monthly payment will change as well. It is worth mentioning that popular ARMs include hybrid loans. This is where the initial interest rate remains locked in for the initial three, five, or even ten years and then the rate adjusts after that.
We can define the adjustable-rate mortgage (ARM) index as the benchmark interest rate to which the lender ties any adjustable-rate mortgage. Keep in mind that the interest rate of an adjustable-rate mortgage consists of an index value and a margin. The lender sets the index based on the market conditions. On the other hand, the lender will determine the margin after receiving your application for the loan. It is worth noting that the lender adds the margin and index and this becomes your interest rate at the time your initial rate expires.
Also, remember that the index underlying your adjustable-rate mortgage is often variable. On the other hand, the margin is usually constant. Note that there are many popular indexes used for different kinds of ARMs in the US.
Keep in mind that various programs tend to qualify ARM borrowers, like you, differently than they will do fixed-rate borrowers. For example, FHA will qualify you at the note rate. In contrast, Fannie Mae and Freddie Mac can qualify 10/1 and 7/1 applicants at the note rate; however, they may add 2 percent to the qualifying interest rate of a 3/1 loan applicant.
Still, some lenders in the market use the “fully-indexed rate,” and this is the rate that your loan would be in case it were adjusting today based on the terms. So, in case your 3/1 rate resets to 3.5 if it were adjusting now, that can be your qualifying interest rate. In most cases, it all depends on your loan terms as well as the lender.
It is important to understand this. Each index has its unique characteristics and traits that set it apart from others. The London InterBank Offered Rates (LIBOR), as a global index, is a reliable barometer for the international economy. This is why investors and lenders who operate internationally use it.
Keep in mind that this index depends mainly on the interest rate charged among various banks based on borrowing transactions between each other.
The LIBOR index is typically used as an ARM index in order to cover intervals that can be 1 month, 3 months, 6 months, or 1 year. The prime lending rate index focuses mainly on the US as a market tied to the country’s banking system. Note that it’s a short-term interest rate used commonly by all types of lenders in the country, such as credit unions, commercial banks and other financial institutions. In addition, the prime rate helps to price short-term as well as medium-term loans, or even for adjustments at specific intervals on many long-term loans.
It is worth noting that ARMs tend to operate differently compared to fixed-rate loans. Also, there are a couple of factors that often go into setting ARM rates in the US; hence, it’s vital to understand what these factors are. The title of the ARM that you choose often depends on how it works. A 5/1 ARM, for instance, has a fixed interest rate and payment during the first 5 years, and then the rate resets annually, as per its terms.
This is also sometimes known as “teaser rate.” It is important to note that without this low start rate, nobody would ever choose an ARM over a fixed rate. This is because you will be taking on additional risk without receiving any reward. The lower start rate of the ARM is your reward for bearing some of the risks that is normally assumed by the lender or bank — the risk that interest rates in the country may increase a few years in the future.
You will pay the “fully-indexed” rate when the start rate expires. This interest rate, however, is subject to a few limitations known as “caps” and “floors.” You will have to add 2 figures — an index and the margin in order to calculate the fully-indexed rate. Lenders use this rate sometimes to qualify you for a mortgage.
Note that the index is a published and reliable measurement of financial activity. Some of the common indices are as follows:
Keep in mind that movements in the index rate on which the ARM is based determine whether or not your rate drops or increases when it resets.
You should know that adjustable-rate mortgages usually include many kinds of caps that help control how your interest rate may adjust. Note that there are three main types of caps.
Note that this cap indicates how much your interest rate may increase the first time that it adjusts once the fixed-rate period expires. This cap is usually either 2 or 5 percent.
On the other hand, this cap indicates how much your interest rate may increase in the following adjustment periods. And this cap is commonly 2 percent.
Finally, this cap states how much your interest rate may increase in aggregate, over the life of your loan
Compared to fixed-rate mortgages, ARM rates are more complicated. This is why shopping for them can be a little different too. One of the easiest ways to shop for your ARM loan is choosing one that has a start rate period close to the time when you expect to own your home.