Adjustable Rate Mortgages (ARM)

ADJUSTABLE RATE MORTGAGES (ARM)

An Adjustable Rate Mortgage (ARM) is a type of home loan where the interest rate can change over time. Unlike fixed rate mortgages, which have a constant interest rate for the entire loan term, ARMs typically start with a lower fixed interest rate for an initial period and then adjust periodically based on market conditions. This initial lower rate often allows borrowers to qualify for a larger loan amount or a more expensive home, making ARMs an attractive option for some homebuyers.

HOW ADJUSTABLE RATE MORTGAGES WORK

ARMs offer an initial fixed interest rate period that can range from as short as one month to as long as 10 years. During this period, your interest rate remains stable, much like a fixed rate mortgage. However, once the initial period ends, the interest rate can change periodically—usually annually—based on an index and margin.

Index: The index is a financial benchmark that reflects general market conditions. Common indices used for ARMs include the 1-Year Treasury Security, the London Interbank Offered Rate (LIBOR), the Prime Rate, the 6-Month Certificate of Deposit (CD) Rate, and the 11th District Cost of Funds Index (COFI).
Margin: The margin is a fixed percentage added to the index to determine your new interest rate. Margins generally range from 1.75% to 3.5%, depending on the specific ARM product and the loan-to-value ratio (LTV) of your mortgage.

When your ARM adjusts, the lender adds the current value of the index to your loan’s margin, which determines your new interest rate. This adjusted rate is then fixed until the next adjustment period.

ARM CAPS: PROTECTING BORROWERS FROM RATE SPIKES

To protect borrowers from significant rate increases, ARMs often come with caps that limit how much the interest rate can change. There are three main types of caps to be aware of:

Initial Adjustment Cap: This cap limits the amount your interest rate can increase during the first adjustment period after the fixed-rate period ends. For example, if your ARM has an initial adjustment cap of 2%, your rate cannot increase by more than 2 percentage points in the first adjustment, even if market rates have risen significantly.
Subsequent Adjustment Cap: This cap limits how much the interest rate can change in subsequent adjustment periods. Typically, this is also 2% per adjustment period, but it may vary depending on your loan terms.
Lifetime Cap: The lifetime cap limits the total increase allowed over the life of the loan. For example, if your loan has a 6% lifetime cap, your interest rate cannot increase by more than 6 percentage points above your initial rate, regardless of how high market rates climb.

ARM Example

Consider a “3/1 ARM” with the following features:

Initial Rate: 6.25%
Initial Fixed Period: 3 years
Initial Adjustment Cap: 2%
Lifetime Cap: 6%

In this example, your interest rate would be fixed at 6.25% for the first three years. When the loan adjusts in the fourth year, the rate could increase by no more than 2%, meaning the highest possible rate would be 8.25%. Over the life of the loan, your interest rate could increase by a maximum of 6 percentage points from the initial rate, capping it at 12.25%.

KEY BENEFITS OF ADJUSTABLE RATE MORTGAGES (ARM)

Lower Initial Rate: ARMs often start with a lower interest rate than fixed rate mortgages, which can help you qualify for a larger loan or reduce your initial monthly payments.
Flexibility: ARMs are ideal for borrowers who plan to sell or refinance their home before the initial fixed-rate period ends, allowing them to take advantage of the lower rate without worrying about future adjustments.
Rate Caps: Built-in caps limit how much your interest rate can adjust, offering protection against significant rate increases.
Potential for Lower Payments: If interest rates fall during your adjustment periods, your monthly payments could decrease, allowing you to benefit from the lower market rates.

IS AN ARM RIGHT FOR YOU?

Adjustable rate mortgages can be a good option for homebuyers who:

Plan to sell or refinance their home before the initial fixed-rate period ends
Want to take advantage of lower initial interest rates
Are comfortable with the possibility of future rate adjustments
Expect their income to increase in the coming years, making potential rate increases easier to manage

However, ARMs also carry some risk. If interest rates rise significantly, your monthly payments could increase, potentially making the loan less affordable. It’s important to carefully consider your financial situation and future plans when deciding if an ARM is the right choice for you.

Let Top7 Mortgage Help You

At Top7 Mortgage, we’re here to help you understand the ins and outs of adjustable rate mortgages. Our experienced team will guide you through the loan process, explain the details of your ARM, and ensure that you’re fully informed about the potential benefits and risks.

Contact us today to learn more about Adjustable Rate Mortgages and find out if this flexible loan option is the right fit for your homebuying needs.

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