Adjustable rate mortgages are a type of mortgage that has an initial interest rate for a set period of time. After that, your interest rate and payments go up or down, based on an index rate.
The index rate is comprised of two parts: a benchmark variable interest rate and a margin. The benchmark or index rate is publicly available and published regularly. A few market indexes include LIBOR (London Interbank Offered Rate) and T-Bill (U.S. Treasury Bill). Each ARM is tied to a specific market index specified on your loan contract.
The ARM margin, or spread, is essentially the lender’s profit. It is an agreed-upon number of percentage points and does not change throughout your loan. The margin is added to the index rate to calculate your new interest rate.
ARMs are also known as variable-rate or floating rate mortgages.
The interest rate on your ARM is the index rate plus the margin. For example, if the index rate on your ARM is 3% and the margin is 2%, then your interest rate is 5%. Next year, if the index is 2.25%, then your interest rate will drop to 4.25%. Most ARMs will do this calculation every year after the loan’s fixed period has ended.
Fortunately, there are interest rate caps and payment caps to protect the borrower. First, periodic rate caps that limit how much the interest rate can change from year to year. Next, there are lifetime rate caps, which are required by law, that limit how much the interest rate can increase over the loan term. Finally, there are payment caps that limit how much your actual mortgage payment can increase. In general, ARMs with periodic rate caps do not have payment caps.
An ARM is usually described using two numbers, such as 5/1, 3/1 or 10/1. The first figure is the number of years that your interest rate is locked in. The second number is how often adjustments can be made to the interest rate after the introductory period has passed.
For example, a 5/1 ARM translates to 5 years at a fixed interest rate and then adjusts every year for the duration of the loan. One exception is the 5/6 ARM, which has a set rate for five years and then changes every six months.
Borrowers are attracted to ARMs because the initial interest rates are usually lower than a fixed rate mortgage. As a result, your monthly payment is lower during the introductory period. Furthermore, if the interest rate drops, you will save money on your mortgage payments.
ARMs are considered riskier because your interest rate can possibly increase after the fixed period is over. You have less control over your budget, as your mortgage payment will rise and fall, depending on the market interest rate. With an ARM, you must be comfortable with the idea of higher payments in the future when your interest rate adjusts.