Adjustable Rate Mortgages (ARMs) Definition

adjustable rate mortgage

These are mortgage plans providing a limited period of lower fixed rates after which the interest rate will be changed. Such loans are often quoted as either 3/1 or 7/1, where the first number is the initial fixed-rate period and the second number is the frequency at which the rate will be changed after the fixed-rate period. Many lenders are providing initial fixed-rate terms for 1, 3, 5, 7 and 10 years after which the rate will be changed after 1 year.

A 3/1 ARM with a rate of 6.00 percent, for instance, implies a fixed rate at 6.00 percent for 3 years that will be changed every 1 year afterward. Therefore, an ARM of 3/1.

ARMs typically have a lower interest rate than a fixed-rate mortgage for 30 years. The trade-off is the probability that the interest rate will rise over a period of time after the initial fixed-rate period.

Here are some things you should know when shopping for an ARM: What’s the limit that an ARM can go up or down when it’s adjusted?

Depending on the mortgage lender and the initial fixed-rate duration, the maximum a price can go up or down varies. You need to decide the limit, margin, and index of the loan while shopping for an ARM.

What’s Caps?

Usually, there are 2 caps; a cap per modification and a lifetime limit. A limit per adjustment is the maximum rate that can be raised or lowered in any year of adjustment. A lifetime cap is the maximum rate that can be extended over the loan’s entire term. For example, the maximum the price could go up or down in any adjustment year is 2 percent above the current rate, a 2 percent adjustment cap. 

If the current rate on your ARM is 6.00%, the maximum rate that you could charge for the next adjustment year is 8%. A lifetime limit of 6% means that the highest interest rate you could ever pay in any year is 6% above the starting rate or 12%. Your new rate is connected to an index giving a margin to the borrower.

What is an Index and Margin?

Mortgage interest rates are tied to current market conditions and a good measure of market conditions is yields on treasury securities. The index is normally the weekly average yield on a 1, 3 or 5 Year Treasury Security 30 or 45 days before your adjustment date. Keep in mind a 1 Year Treasury yield is lower than a 5 Year Treasury yield.

To this index, the lender will add a margin of X% determined solely by the lender. A lender could add a margin of 2.25%, 2.5% up to or greater than 3% to the index to determine your new rate. When shopping for an ARM you want to look for the lowest term treasury security index with the lowest margin.

What does all this mean?

The Caps, Margin and Index play an important deciding factor when shopping for an ARM. For example; you have been quoted the following rates and terms on a 3/1 ARM both with a 1 Year Treasury Security index:

  • Loan #1 – Rate 6.00%: Caps are 2% per adjustment, 6% lifetime with a Margin of 2.75%
  • Loan #2 – Rate 6.125%: Caps are 2% per adjustment, 5% lifetime with a Margin of 2.50%

Loan #1 seems to be a good loan on the ground, as the interest rate is 1.125 percent lower than loan #2 and that holds if you plan to move or refinance your loan at the end of three years. But if there’s a possibility you’re going to keep the loan over 3 years, loan #2 is probably the best way to go because 1) when loan #2 is changed, the rate will always be 0.25 percent below loan #1 (unless the maximum 2 percent is adjusted) and 2) the lifetime limit is 1 percent below loan #1.

How do I decide if an ARM is right for me? Here are some things to consider:

Perhaps the most important factor in deciding whether or not an ARM is for you is the initial fixed-rate duration and the second most important factor is the margin and index.

  • Would you expect to stay in your home for a term below or equal to the loan’s initial fixed-rate duration?
  • If your boss transfers or is moved regularly, there may be an ARM for you. The ARM will give you lower interest rates and expenditures as long as you’re still at home. Would you like to live in your new home for five years? The best way to go could be a five-or seven-year ARM.
  • Do you think that over the next X number of years you should refinance your loan? Statistics show that most homeowners either transfer their loan or refinance it within seven years. Whether you believe or have encountered these figures yourself, there might be a 7-or10-year ARM for you.
  • Need a low-interest rate to qualify for your dream home? Since an ARM usually provides a lower interest rate than a mortgage with a fixed rate, you may be able to qualify for a higher loan or more expensive home. Keep in mind, though, unless you are in a position to refinance the loan in X years, the interest rate will increase and you want to make sure that you are still able to cover the monthly payments. You may be best off with a fixed-rate loan if you have the funds available and lower this rate by charging premiums.
  • ARM’s aren’t for all. If you don’t have the possibility of having to refinance and charge a possibly higher interest rate, with a fixed-rate mortgage, you may be better off.

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Marc-Antoine Boivin
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