Adjustable Rate Mortgage

An adjustable rate mortgage is, as the name implies, one that can change, or adjust. But the adjustments are based upon specific mechanics spelled out in the note as to both how and when the rate can change. Adjustments aren’t spontaneous. Adjustable rate mortgages, or ARMs, are also referred to as a variable rate loan.

Why would someone choose a mortgage loan program that has an interest rate that can go higher or lower at different times in the future? An adjustable rate will have a lower, “teaser” rate at the very beginning of the loan term, lower than a corresponding fixed rate over the same period. For instance, a 30 year fixed rate might be listed one day at 4.25% while an adjustable rate loan starts out at 3.75%. How and when do adjustable rate mortgages change?

An adjustable rate mortgage is made up of several components. An index, margin, initial cap and lifetime cap. When a loan is going to adjust, the lender seeks out the appropriate index, adds the margin to it with an eye on interest rate caps. For example, say that an adjustable rate loan is based upon the 1-year Constant Maturity Treasury, or CMT. When it’s time to adjust and the index is 2.00 and the margin is 2.00, the new rate until the next adjustment is then 2.00 + 2.00 = 4.00%. If the selected index takes a wild swing in one way or the other, the movement is limited by the rate cap. A common rate cap is 2.00% over the previously listed rate.

Let’s say for instance the index used jumped from 2.00 to 8.00. That scenario isn’t likely to ever happen, but for explanation purposes, let’s use 8.00. When it’s time to adjust, the “fully indexed” rate is 8.00 + 2.00 = 10.00%. At the very beginning of the loan term the rate was 3.75% but the fully indexed rate is much higher than that at 10.00%. This is such a change that it’s likely the borrowers would have some trouble paying the mortgage payment when it’s nearly three times what it used to be. That’s where caps come into play.

Because this program had an initial rate cap of 2.00%, even though the fully indexed rate was at 10.00, the new rate until the next adjustment could only be 2.00% higher than the previous rate, or in tis example, from 4.00% to 6.00%. Each year when the rate adjusts, the same method is used to figure the new rate. If the 1-yr CMT went down the following year, let’s say back down to 5.00%, the newly adjusted rate would be 5.00 + 2.00 = 7.00%. This new rate is below the 2.00% annual cap, so the newly adjusted rate will then be 7.00% for the following year.

There is also a lifetime cap that will limit how high the rate can ever be over the life of the loan. If a lifetime cap is 5.00%, in this example the rate on the mortgage could never be higher than 9.00%, which is 5.00% higher than the initial rate.

Today however, most adjustable rate loans come in the form of what is referred to as a hybrid mortgage. A hybrid is so-called because it mimics a fixed rate loan in its early stages before turning into a loan that can adjust once per year. How long is the initial rate fixed? That, too is built into the note. Hybrids are in the form of 3/1, 5/1, 7/1 and 10/1 options. The first number indicates how long the rate is fixed at the inception of the note and the second digit is when the rate can adjust, or in this example, 1

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