An ARM is a mortgage with an interest rate that may vary over the term of the loan -- usually in response to changes in the prime rate or Treasury Bill rate. The purpose of the interest rate adjustment is primarily to bring the interest rate on the mortgage in line with market rates.
Mortgage holders are protected by a ceiling, or maximum interest rate, which can be reset annually. ARMs typically begin with more attractive rates than fixed rate mortgages -- compensating the borrower for the risk of future interest rate fluctuations.
Choosing an ARM is a good idea when:
ARMs have the following distinguishing features:
An adjustable rate mortgage's interest rate increases and decreases based on publicly published indexes. ARMS are based on different indexes including:
Margin is a fixed percentage amount that is pointed added to the index - accounting for the profit the lender makes on the loan. Margins are fixed for the term of the loan.
interest rate = index + margin
Interest rate caps put limits on interest rates and monthly payments.
Common caps:
An initial adjustment cap limits how much the interest rate can change at the first adjustment period.
Example:
If your ARM has a 1% initial adjustment cap, your interest rate may only increase or decrease by a maximum of 1% at the first adjustment period.
A periodic adjustment cap limits how much your interest rate can change from one adjustment period to the next. Usually a six-month adjustable rate mortgage will have a one percent periodic adjustment cap while a one-year adjustable rate mortgage will have a two percent periodic adjustment cap.
Example:
If your loan has a 2% periodic adjustment cap, your interest rate may only increase or decrease by a maximum of 2% per adjustment period.
A lifetime cap sets the maximum and minimum interest rate that you may be charged for the life of the loan. Most ARMs have caps of 5% or 6% above the initial interest rate.
Example:
If your loan has a 6% lifetime cap, your interest rate may only increase or decrease by a maximum of 6% for the life of the loan.
Initial adjustment caps, periodic adjustment caps, and lifetime caps make up an adjustable rate mortgage's cap structure, and are usually represented as three numbers:
Example:
1/2/6 -- Initial adjustment cap is 1 %/ periodic cap is 2% / lifetime cap is 6%.