What is an ARM?
Adjustable rate loans, as the name implies, has an interest rate that can change throughout the life of the loan. Borrowers select an adjustable rate mortgage program due to the lower start rates on these mortgages. Adjustable rate mortgages, or ARMs have rates that can adjust once per year or can be in the form of a hybrid where the initial interest rate is fixed for a predetermined period before changing into a loan that can adjust once per month. Most adjustable rate mortgages today come in the form of these hybrid loans which have initial fixed terms of 3, 5, 7 and 10 years.
Key Benefits of an ARM
An ARM has a lower start rate compared to a fixed rate loan
An ARM can increase buying power due to the lower rate
Ideal solution for shorter term ownership
How does an ARM work?
An adjustable rate mortgage is based upon an index, a margin and caps. Once the initial fixed term is coming to a close, the borrower is made aware of what the new rate will be for the coming year. A common index today lenders use is the Constant Maturity Treasure, or CMT. A common CMT today is the One-Year CMT. When a hybrid is about to adjust, a margin is added to the index. A common margin is 2.00%.
When adding the margin of 2.00% and the 1-Year CMT is 1.50%, the new interest rate for the following year is then 3.50%. One year later, the index is referred to once again and the 2.00% margin is added for the next year’s rate.
ARMs also have interest rate caps, or simply “caps.” A cap is a consumer protection feature that limits how much a rate may change upon adjustment. The initial cap limits how much the rate can be after the hybrid period has elapsed. An annual cap limits how much the rate can change from year to year and a lifetime cap is how much the rate can change over the life of the loan. Different adjustable rate programs can have different caps.
Frequently Asked Questions
- Can I refinance an ARM later on if I decided to own the property longer and get a fixed rate?
- Are closing costs higher with an ARM?
Yes, you can refinance an adjustable rate mortgage into a fixed rate loan at any time.
No, closing costs are the same regardless if the loan is an ARM or a fixed.
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