Adjustable Rate Mortgage

Adjustable Rate Mortgage

An adjustable rate mortgage, or ARM, is the second most popular type of mortgage behind fixed rate mortgages.

As the name would imply, an adjustable rate mortgage is a mortgage where the interest rate of the loan "adjusts" at predetermined intervals throughout the life of the loan. As the rate adjusts, so does the monthly payment of principal and interest.

A hybrid ARM or hybrid loan is an adjustable rate mortgage whose rate remains fixed for some initial period before regular adjustments occur. For the period of time that the interest rate is fixed, the principal and interest payment also remains fixed. From a consumer's point of view, and the point of view of most advertising, both ARMs and hybrid ARMs are simply called ARMs or adjustable rate mortgages. Common periods for fixed interest rates and payments on ARMs are 6 months, 1 year, 3 years, 5 years, 7 years, and 10 years.

Conforming and Nonconforming Adjustable Rate Mortgages

Similar to fixed rate mortgages, adjustable rate mortgages may also be either conforming, or non-conforming (also known as "jumbo"). A conforming adjustable rate mortgage is an ARM with a loan amount that does not exceed the loan limits set by the Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). These loan limits are (as of January, 2006):

  • 1-family loans: $417,000
  • 2-family loans: $533,850
  • 3-family loans: $645,300
  • 4-family loans: $801,950

Note: The limits for one to four family loans in Alaska, Hawaii, Guam, and the U.S. Virgin Islands are fifty percent higher.

A jumbo or nonconforming adjustable rate mortgage is an ARM that is over these loan limits.

Adjustable Rate Mortgage Term

As is true of all mortgages, adjustable rate mortgages have a term, or the amount of time that it takes for the loan to be paid off. The most common term for adjustable rate mortgages is thirty years, although 15 year ARMs do exist.

Adjustable Rate Mortgage Points

Many advertisements for adjustable rate mortgages will commonly quote both an interest rate and points. A point is equal to 1% of a loan's value. Points are used to lower the initial interest rate on a loan. In general, the more points on an ARM the lower the ARM's initial interest rate. Adjustable rate mortgages are also available with no points.

Adjustable Rate Mortgage Features

Adjustable rate mortgages have four basic features:

  1. An initial interest rate - The initial interest rate of an ARM is the interest rate that the mortgage loan starts with.
  2. Adjustment intervals - An ARM will typically have two adjustment intervals. The first is the amount of time until the first adjustment, this is also the amount of time that an ARM may have a fixed rate of interest and payment. The second adjustment interval is for adjustments after the initial adjustment interval. An ARM may have a 3 year initial adjustment interval, followed by adjustments every year. This would be called a 3/1 ARM. The first number is the initial adjustment interval, the second is the subsequent adjustment interval. A 3/1 ARM's interest rate and payment remains the same for the first three years of the loan, after which it adjusts every year. Similarly you may see 5/1 ARMs, 7/1 ARMs, and even 10/1 ARMs.
  3. ARM index - An adjustable rate mortgage's interest rate goes up and down according to some nationally published interest rate index. Some of the indices used for ARMs include:
    • 12-Month Treasury Average (MTA or MAT)
    • Certificate of Deposit Index (CODI)
    • COFI or the 11th District Cost of Funds Index
    • Constant Maturity Treasury (CMT or TCM)
    • Cost of Savings Index (COSI)
    • LIBOR or the London Interbank Offering Rate
    • Treasury Bill (T-Bill)

    The CMT, COFI, and LIBOR are the most commonly used indices for ARMs. There are other lesser known indices as well.

  4. Margin - The margin gets added to the index to determine what interest rate the lender charges the consumer. It is, in essence, the markup over the index. For example, if the index interest rate is 5%, and the margin is 2.5%, than the resulting interest rate to the consumer is 7.5%. It is this calculation that the lender performs at each adjustment interval to determine what the new interest rate will be on an ARM. It should be noted that it is common for the initial interest rate on an adjustable rate mortgage to be below the sum of the index and the margin.

There are also many optional features to adjustable rate mortgages. These features are often, but not always, present in adjustable rate mortgages. Optional features that may be included in some or most ARMs include:

  • Lifetime interest rate cap - A lifetime interest rate cap is a cap on the maximum interest rate that may be charged on a particular ARM regardless of what the index plus margin calculation yields for an interest rate. For example, a loan with a 10% lifetime interest rate cap would result in a 10% interest rate even if the index were 8% and the margin were 2.5%, which should yield a 10.5% interest rate for the loan. Lifetime interest rate caps provide protection from being charged exorbitant interest rates in a market of rising interest rates.
  • Periodic interest rate cap - The periodic interest rate cap is similar to the lifetime cap, but it applies to the amount that the ARM's interest rate can increase in any given adjustment interval. For a loan with an annual adjustment interval and a 2% periodic cap, the most that the interest rate could increase at that adjustment interval would be 2%. So if the interest rate going into the adjustment were 4%, and the index plus margin calculation yielded an interest rate of 8%, the periodic cap would kick in and the interest rate would be 6%.
  • Monthly payment cap - A monthly payment cap places a limit on how much your monthly payment may increase from one adjustment period to another. Monthly payment caps can lead to negative amortization (more on negative amortization appears later in this article).
  • Conversion to a fixed rate mortgage - Some ARMs will allow the borrower to convert their loan to a fixed rate mortgage at the prevailing market rates without having to refinance.

Negative Amortization ARMs

Negative amortization is said to occur when a mortgage's monthly payment is not sufficient to cover the interest due on a loan. In this case, the unpaid interest actually gets added to the amount of the loan causing the loan balance to increase. A variant on this would be partial amortization. This would exist when the monthly payment is enough to cover the interest payment but does not cover all of the principal payment due. In both of these instances the loan would still have a balance due at the end of its term.

Negative amortization can arise in ARMs when:

  • The initial monthly payment of the ARM is not sufficient to cover the interest payment.
  • The interest rate adjusts more frequently than the monthly payment.
  • The ARM has a monthly payment cap.

Borrowers should ask if the ARMs they are considering can have negative amortization.

Adjustable Rate Mortgage Options

Similar to other types of mortgages, ARMs may also have numerous other "options". Some of the more prevalent options for ARMs would include:

  • No cost ARMs - Some adjustable rate mortgages may be referred to as "no cost" loans. This would be a case where there are no points and closing costs for the ARM. Typically what happens with these type of loans is that the lender charges a higher interest rate to cover the closing costs.
  • Interest-only - An interest-only adjustable rate mortgage is an ARM where the consumer only pays the interest for some period of time. At the end of the ARM's interest-only period, the loan payment is adjusted to include both principal and interest. The principal payment is calculated to amortize over the remaining term of the ARM.
  • Bi-weekly payments - An ARM that allows bi-weekly payments is an ARM that you pay every other week, or 13 times a year, versus the normal 12 monthly payments a year.
  • Rate locks - Typically, the quoted interest rate and points for an adjustable rate mortgage will allow the borrower to lock the interest rate for some period of time prior to closing (usually thirty days). By paying additional points, the rate lock period may be extended to sixty days and beyond.
  • Low-doc and no doc ARMs - Typically, there are 3 types of documentation required to get any mortgage loan, documentation of income, documentation of assets, and verification of employment. Some ARMs will allow the borrower to qualify for a loan with less than full documentation. Types of diminished documentation loans would include stated income and/or stated assets (which are not verified), no employment verification, and even no documentation at all. Since these types of ARMs are riskier, lenders charge higher interest rates for these loans.

Adjustable Rate Mortgage Terms and Conditions

It is important for the borrower to be aware of some of the more prevalent terms and conditions for adjustable rate mortgages. All mortgage loans have a "due on sale" clause. This means that the mortgage will come due and must be paid off if the borrower sells their home. Some mortgages may also have a "demand clause". A demand clause allows a lender to demand full repayment of a mortgage for any reason.

Some ARMs also have a prepayment penalty. A prepayment penalty is a cash penalty that the borrower pays if they payoff their entire loan before the term of the loan. Prepayment penalties can be "hard", which means that the prepayment penalty will be incurred if the loan is paid off early for any reason including the sale of the home. ARMs may also have "soft" prepayment penalties where the penalty only applies to mortgages paid off by refinancing. Prepayment penalties typically decline over time. Prepayment penalties usually no longer apply after a mortgage is five years old. Many prepayment penalties will still allow the borrower to make partial prepayments.

It is important for the borrower to know if these terms and conditions are present in the ARMs they are considering. Borrowers should ask if there is any prepayment penalty for the ARM that they are considering, or if there is any cause for repayment other than the "due on sale" clause.

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