Adjustable Rate Mortgage

An Adjustable Rate Mortgage loan is a mortgage loan program in which  interest rate periodically adjusts up or down according to a specific index and predetermined margin and within certain limits. As simple as that.

Adjustable Rate Mortgage is also know as ARM

ARM has interest rate that is fixed for as little as 6 months or for as long as 10 years. The payments are normally amortized over 30 years but few years ago, a 40 year amortization was introduced.

Adjustable rate mortgage features

• interest rate adjusts periodically after initial fixed period
• rate adjustments are tied to a published index plus predetermined margin
• rate increase and decrease are limited by interval and lifetime caps
• mortgage payment changes with interest rate adjustments
• some adjustable mortgages  have potential negative amortization

Adjustable rate mortgage periods

The period is a time interval at which interest rate of the ARM loan is readjusted. Interest rate changes once each period.

Periods range from one month to several years, with one-year ARM periods being the most common.

Normally, ARMs with shorter periods have lower interest rates because with shorter intervals interest rates can be increased more frequently and thus further lower lender overall risk.

These days the most popular adjustable mortgages are 1/1 ARM, 3/1 ARM, 5/1 ARM, 7/1 ARM and 10/1 ARM. The start interest rate is fixed for the first one, three, five, seven and ten years respectively and then adjust every one year afterwards.

The lowest start rate usually belongs to the ARM with the shortest fixed period. Often 10/1 ARM or even 7/1 ARM start rate is too close to 30 year fixed mortgage to make any sense.

Indexes

Margin

A predetermined, fixed for the full loan term amount that is added to the index to calculate the Fully Indexed Accrual Rate.

Fully Indexed Accrual Rate (FIAR)

Defined as index plus margin. Each adjustment interval index value will be adjusted to the market conditions and loan rate will be adjusted as well.

Periodic Rate Cap

Limits interest rate increase or decrease from one period to the next, usually is no more than 2%.
If you have an interest rate of 5.50%, even if the index goes up to 14%, the most that your new rate can be is 7.50%.

Payment Cap

Payment cap limits monthly payment increase, not the increase in the rate,  from one period to the next. Normally payment cap is 7%-12% of the current payment. If your ARM loan has a payment cap of 9% and a current mortgage payment of $100, your new payment would be a maximum of $109 per month ($100 x 1.09).

But payment caps do not limit the increases of interest rates. Consequently, payment caps may induce negative amortization, which means that the principal balance increases instead of decreases. Check the ARM disclosure to be sure. Just because the payment increases are restricted does not mean that the interest calculated need not be paid.

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