Adjustable Rate Mortgages, also known as ARMs typically have a term of 30 or 40 years, with an interest rate that is fixed for a specified period or time. Most commonly, the interest rate is fixed for 3, 5, 7 or 10 years.
At the end of the fixed rate period, the interest rate and mortgage payment will adjust, at regularly scheduled intervals, for the remainder of the loan term.
You’ll often see an Adustable Rate Mortgage shown as two numbers, such as a 7/1 ARM. The first number represents the number of years the interest rate is fixed. The second number represents the frequency at which the interest rate will adjust after the fixed period.
For example, a 7/1 ARM is has a rate that is fixed for 7 years, then the interest rate will adjust 1 time per year, thereafter.
What happens when my interest rate adjusts?
When your Adjustable Rate Mortgage is scheduled to adjust, the interest rate will be calculated by adding a predefined Margin to the loan’s Index rate. The Margin, expressed as a percentage rate, will stay the same over the life of the loan. The Index, on the other hand, is a variable rate and will change, because it generally follows current market interest rates. Common Indices include the Prime Rate, the LIBOR or the 1 Yr Treasury. It’s difficult, if not impossible, to predict where interest rates will be 5, 7 or 10 years in the future, so in order to give some level of protection, Adjustable Rate Mortgages have rate adjustment “caps”, to prevent your interest rate from rising too much, each time it adjusts.
What are rate adjustment “CAPS”?
Adjustable Rate Mortgages (ARMs) typically include several types of “caps” that control how much your interest rate can adjust. Rate caps are often shown as three numbers, for example: 2%/2%/6% (or 2/2/6).
The first number represents the maximum percentage an interest rate can increase, at the first interest rate adjustment. It’s called the “Initial Adjustment Cap”. In the 2/2/6 example, the first “2” means that the initial rate adjustment can be no more than 2% higher than initial interest rate, during the previous fixed rate period.
The second number represents the maximum percentage a rate can increase (or decrease) on all subsequent interest rate adjustments. The Subsequent Adjustment Caps follow the Initial Adjustment Cap, for the remainder of the loan term. With the 2/2/6 example, the second “2” means that each subsequent rate adjustment can’t be more than two percent higher than the previous interest rate.
The last number represents the Lifetime Adjustment Cap. The Lifetime Cap indicates how much the interest rate can increase, in total, over the life of the loan. With the 2/2/6 example, the Lifetime Cap is 6%, which means that the rate can never be six percent higher than the initial rate. For example, with a 7/1 ARM that had an initial fixed rate of 3.75% for the first 7 years of the loan: a Lifetime Rate Cap of 6% means that the interest rate on the loan can never (at any time) go higher than 9.75% (3.75% + 6% = 9.75%).
PAYMENT OPTIONS FOR ARMs
Adjustable Rate Mortgages may be amortized, with monthly principal and interest payments, over the standard 30 (or 40) year loan term – or they may have an Interest-Only payment option, during the initial fixed term. As the name implies, an Interest-Only payment covers only the interest due on the loan, and does not pay down or reduce the principal loan balance. An Interest-Only loan can give homeowners greater cash-flow flexibility, given the lower monthly payment. Many Interest-Only loansAn Interest-Only option typically has a slightly higher interest rate than an Amortized Payment Option.
Here’s an comparison between an Amortized ARM and an Interest-Only ARM, based on a loan amount of $500,000.00:
Loan Amount: $500,000.00
7/1 ARM (Amortized)
Interest Rate: 3.750%
Monthly Principal and Interest Payment, fixed for 7 Years: $2,315.58
Loan Amount: $500,000.00
7/1 ARM (Interest-Only)
Interest Rate: 3.875%
Monthly Interest-Only Payment: $1,614.58
You’ll notice that even with the higher interest rate, the Interest-Only payment for a $500,000 loan amount is approx 30% lower than an Amortized Payment.
If you’re considering an Adjustable Rate Mortgage with an Amortized or Interest-Only payment option, please feel free to contact me to discuss your options.