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The moving parts of an ARM

By Trulia | Published: Oct 14, 2009 | 15 Comments

Adjustable Rate Mortgages, or ARMs, got a bad name in the housing crisis that culminated around 2005. Inherently, an ARM is neither a good nor a bad thing—just a legitimate financial instrument that can be used or abused, like a bottle of wine or a sportsmans rifle.

With an ARM, the interest rate changes periodically, usually in some relation to an index such as COFI, the Cost of Funds Index; or LIBOR, the London Interbank Offered Rate. You can find both of these popular indices published every day in the Wall Street Journal.

Initially, lenders often charge lower interest rates for ARMs than for fixed-rate mortgages. This makes the ARM easier to afford, at first, than a fixed-rate mortgage for the same amount. But upward-adjusting rates were the downfall of many homeowners who didn't understand the loan terms they agreed to. Unexpected rate increases led to a common emotional state known as "payment shock."

There are several types of ARMs, including hybrids, with names like 3/1 and 5/1. The first number (in this case, 3 or 5) tells you how many years until the first interest rate adjustment occurs. The second number (the 1) tells you how often the rate will adjust thereafter. There are interest-only ARMs, which allow you to pay only the interest for a set period, perhaps as long as 10 years, and payment-option ARMs, where you choose among various payment amount options.

At a minimum, you should understand the "moving parts" of any ARM:

The initial rate and payment

The initial rate and payment amount on an ARM will remain in effect for a limited period ranging from just one month to five years or more. Rates in the later years of a loan may vary greatly from earlier years, even if prevailing interest rates are stable.

The adjustment period

The interest rate of an ARM, along with the monthly payment, may change monthly, quarterly, yearly, or after three, four, or five years. The period between rate changes is called the adjustment period. A loan with an adjustment period of one year is called a one-year ARM and its interest rate and payment can change annually. A loan with a three-year adjustment period is called a three-year ARM.

The index

Lenders base ARM rates on a variety of indexes, such as COFI and LIBOR, mentioned earlier. If the index rate moves up, so does your interest rate, and usually, so does your monthly payment. If the index rate goes down, your monthly payment could go down, but not all ARMs adjust downward. The terms are found in the fine print of the loan. Your payments will also be affected by "caps" and perhaps by lower limits affecting how high or low your rate can go.

The margin

To set the interest rate on an ARM, lenders add a few percentage points to the index rate. That addition is called the margin, and in most cases it's constant over the life of the loan. The "fully indexed" rate equals the margin plus the full index. In a period when the loan rate is less than the fully indexed rate, the rate is said to be "discounted." For example, if the lender uses an index that currently is 4.5 percent and adds a 2.5 percent margin, the fully indexed rate is 7 percent.

If the index on this loan rose to 5.5 percent, the fully indexed rate would be 8 percent. (5.5 plus 2.5 percent) A lender may base the amount of the margin in part on your credit history and the better your credit, the lower the margin. In comparing ARMs, look at both the index and margin for each program.

Interest Rate Caps

Interest rate caps place a limit on the amount your interest rate can increase. Interest caps can take two forms:

A periodic adjustment cap limits the amount the interest rate can adjust up or down from one adjustment period to the next after the first adjustment. A typical sort of cap per period is one percent. Suppose your initial rate is 5 percent and your periodic adjustment cap is one percent. Even if the underlying index (such as LIBOR) jumps by several percent, your new rate can only go to 6 percent in that year.

A lifetime cap limits the interest-rate increase over the life of the loan. All ARMs must have a lifetime cap, by law. Suppose your ARM starts out with a 6 percent rate and the loan has a 12 percent lifetime cap. The rate can never exceed 12 percent. Even if the underlying index rate increases 1 percent each year for a decade, your highest possible rate is 12 percent.

Payment caps

In addition to interest rate caps, many ARMs, including so-called payment-option ARMs, limit the amount your monthly payment may increase at the time of each adjustment. If your loan has a payment increase cap of 7 percent, your monthly payment won't increase more than that amount even if interest rates rise more. But any interest you don't pay will be added to the loan balance. A payment cap can limit the increase to your monthly payments but can also add to the amount you owe. (This is called negative amortization.)

Comments

By Jay Sondhi,  Thu Dec 3 2009, 12:57
An interesting feature of FHA ARMs are the caps. Most caps on FHA ARMs are set at 1/1/5. This means that your rate can only go up or down 1% at the very first change and every change thereafter.

In contrast, freddie/fannie and most other ARMs have a 5/2/5 structure which means that your rate can go up as much as 5% (or the lifecap) during the initial change.

With today's rates for instance, it means that you can get a 5/1 ARM at 4.375% which really acts like a 7/1 ARM with a maximum rate of 6.375%. This is a great option for folks with shorter ownership time horizons.
By Scott Lambert,  Fri Feb 26 2010, 16:03
Given the current credit environment and loan performance, lenders throughout our industry continue to tighten underwriting guidelines and credit standards for FHA loans as well as conventional loans. Many lenders have established a Minimum FICO as a credit management tool. US Bank does not require a 620 FICO Score for Retail Customers through
Scott Lambert on their FHA Loans but prefers to utilize a formalized exception process for loans with low FICO Scores as its way to manage risk.

No credit score is acceptable provided that the borrower can prove a rental rating and three additional alternative credit accounts.

We don't have a interest rate penalty on our FHA Loans below 620.

Contact me at scott.lambert1@usbank.com.
By Voices Member,  Mon Oct 11 2010, 14:22
3 year arms are around 3.0%

5 year arms are around 3.25%

7 year arms are around 3.375%

10.11.10

***If you're looking for a short-term refi or relocation, a 5 or 7 year ARM my be a great deal for the right candidate. Especially, if you're buying over $400,000...
By Alex & Carlos Aguilar,  Wed Oct 27 2010, 17:52
I know this was talked about above but as a client, make sure you compare apples to apples when you are shopping for a loan and the index can be something that you overlook. The lower the index the better the loan option.
By Roger Radcliff,  Sat Feb 19 2011, 21:59
NEVER use an ARM (Adjustable Rate Mortgage) Use a 15 year mortgage. You'll thank me in 15 years.
By Fran Rokicki,  Sat Feb 26 2011, 13:20
An ARM can be good if you know that you will not be keeping the home for a long period of time. The ARM's have remained low, over the last five years. No way to know how long this will last. If you are in an ARM and the rates start to rise, you can look into switching over to a fixed rate.
By Mark Turcich,  Sat Mar 12 2011, 19:37
Hi Fran,
I agree with you. Most lenders will modify
an ARM for you to a fixed rate if your are
a good risk, and they fear losing your
loan to a competitor through a refinance. This happens all the time.
Mark Turcich
chicagoland- mortgage-banker
By MARCO HAUMAN,  Fri Apr 1 2011, 13:07
ARM's are good short term loans!!! Just need to be understood adequately, like anything else.
By Alex Echeandia,  Fri May 6 2011, 13:10
People should not make bold statements, about "always" or "never", it depends on the specific situation and borrower. an ARM can be good, if you educate the borrower as how an ARM works and the what could happen when it adjusts. Also, on Fannie 3 and 5 yr ARMs, you need to qualify at the note rate plus 2%. You should look at a 7yr ARM, you qualify on the note rate.
By Deborah Garvin,  Sat Jun 11 2011, 16:17
If I may, there are a couple misnomers in this post:

1). Most lenders qualify a 3/1 arm at the fully indexed rate, not the start rate. Most of the time, qualification for the 3/1 is pretty equal to a fixed rate and would be used for payment purpose (borrower choice), not qualification.

2). Caps for 5/1 and 7/1 arms can vary widely; however, the vast majority have caps of 5/2/5. Translated to layman's terms, at the end of the initial fixed period (5 or 7 years) the initial adjustment is POTENTIALLY equal to the lifetime cap. Many, many people are not informed of this fact.

ARM's are great products for the right person and the right situation; however, a consumer should always request to see the ARM disclosure prior to choosing a specific ARM product.
By John Leavitt NMLS #20988,  Sun Jun 12 2011, 11:17
An adjustable rate mortgage, called an ARM for short, is a mortgage with an interest rate that is linked to an economic index. The interest rate, and your payments, are periodically adjusted up or down as the index changes.
If you plan living in your home for 5 years or less I would look at 7 year ARM.
By Edward Dubinsky,  Thu Jul 7 2011, 13:57
99.9% of all Mortgages written are closed end. This means that if you pay extra towards principle the payment is unchanged. For primary resident buyers an ARM mortgage will give the opportunity to offset payment shock and invest the savings to accelerate the equity position. The reality is that every homeowner gets curious to save money sooner than the arm period expires. Refinancing opportunities with accelerated equity building will guarantee savings. Currently at 4.5% for every 1k borrowed the cost is $5.06 per month. At 7% the cost increases to $6.65. So if rates increase and your balance decreases by 10k you will still be eligible to save approx 35.00 per month. If the ARM payment saves you even a $100.00 per month consider hedging the rick by paying the additional savings towards principle. The most common ARM I advice is the 7/1 FHA or conventional and I let the numbers do the taking. However for Investment property acquisitions I always advise a Fixed Rate term. The monthly rental revenue earned should remain unchanged or gradually increase with inflation.
By Edward Dubinsky,  Thu Jul 7 2011, 13:57
99.9% of all Mortgages written are closed end. This means that if you pay extra towards principle the payment is unchanged. For primary resident buyers an ARM mortgage will give the opportunity to offset payment shock and invest the savings to accelerate the equity position. The reality is that every homeowner gets curious to save money sooner than the arm period expires. Refinancing opportunities with accelerated equity building will guarantee savings. Currently at 4.5% for every 1k borrowed the cost is $5.06 per month. At 7% the cost increases to $6.65. So if rates increase and your balance decreases by 10k you will still be eligible to save approx 35.00 per month. If the ARM payment saves you even a $100.00 per month consider hedging the rick by paying the additional savings towards principle. The most common ARM I advice is the 7/1 FHA or conventional and I let the numbers do the taking. However for Investment property acquisitions I always advise a Fixed Rate term. The monthly rental revenue earned should remain unchanged or gradually increase with inflation.
By Valeryhoward,  Mon Jan 9 2012, 17:02
The house at 1825 Wedgewood Drive was sold by Chase bank 3 years ago. Please stop showing this listing. The new owner. Thanks January 9, 2012
By Lake Placid Homes,  Sun May 20 2012, 22:07
Very nice! I am looking for this type of info and sometimes I get lucky like today...:-). Thanks for your post.
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