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 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 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.
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.
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 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.
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.)