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