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 Adjustable-rate Mortgages
Adjustable-rate mortgages (ARM) are popular because they usually start with a lower interest rate, so your monthly payments are lower. This allows you to qualify for a larger mortgage than would be possible with a fixed-rate mortgage. The interest rate on an ARM is adjusted periodically based on an index that reflects changing market interest rates.
Below is an overview of the adjustable-rate mortgage.
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Arms have a lower initial interest rate than fixed-rate mortgages. The difference in cost may allow you to qualify for a more expensive home.
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Arms can be a good choice when interest rates are high. If interest rates are high when you get the mortgage but drop over the initial period or any subsequent adjustment period, your monthly payment may decrease.
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An ARM that has its initial adjustment after the 5th or 7th year can save you money if you plan to stay in your house that long.
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All ARM interest rate adjustments are based on a published market index. Some frequently used indexes include Certificate of Deposit, U.S. Treasury Bill, Cost-of-Funds, and LIBOR.
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Arms have defined adjustment periods that determine how frequently the interest rate can change. The initial period before the first adjustment can be short (1 or 3 years) or quite long (7 or 10 years). After the initial period the interest rate on most Arms adjusts every year.
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Once the initial period is up, the interest rate can increase or decrease based on an index plus a certain percentage, known as the margin. Arms have rate caps, or ceilings and floors, on how much the interest rate can increase, and in some cases, decrease.
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There are caps on the amount of the interest rate increase or decrease on the first change date after the initial period, on each subsequent periodic adjustment and over the life of the loan. For example, a 5/1 ARM may have a 5% cap on the change in the interest rate on the first change date (after the 5 year initial period), a 2% cap on the change in the interest rate each year after the first change date, and a 5% cap on the increase (but not the decrease) over the term of the loan.
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Even though the interest rate on an ARM may increase over the term of your mortgage, it may still be a good choice if you expect your income will increase over the life of the loan because your initial payments are lower than with a fixed-rate mortgage. When the interest rate and your payments increase, you will still be able to make the payments from your higher income.
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Types of ARMS
There are many different types of Arms The most common are: 10/1 ARM, 7/1 ARM, 5/1 ARM , 3/1 ARM and 1/1 ARM.
The first number is the length of the initial period - how long it is until the first interest rate adjustment. For example, the interest rate on a 10/1 ARM will not change for the first 10 years but can change in the 11th year. People often plan to sell or refinance their home before the end of the initial period.
For more information, see the following link to a publication of the Federal Reserve Board entitled Consumer Handbook on Adjustable Rate Mortgages:
http://www.federalreserve.gov/pubs/brochures/arms/arms.pdf
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