A mortgage with an interest rate that can change during the term of the loan. The timing and calculation of adjustments (also called resets) are determined by the loan program, and these details are disclosed in the mortgage documents.
When lenders make fixed-rate mortgages, they take on what’s called “interest rate risk.” That’s the chance that market interest rates (for example, what banks pay their depositors) will rise to the point that lenders actually lose money on their loans. Adjustable rate mortgages are safer for lenders because they can raise their interest rates if that happens.
However, ARMs are riskier for borrowers. To convince borrowers to choose ARM products, lenders offer them at lower interest rates. Those lower rates can provide ARM borrowers with a significant advantage.
Borrowers should understand these common elements of ARMs completely before committing to an adjustable mortgage.
Start rate. This is also called the introductory rate, or teaser rate. The start rate is the interest rate used to calculate the first payment(s) the borrower will make. This start rate may be in effect for 30 days to ten years, depending on the loan terms.
Introductory period. This is the length of time the start rate applies. Once the introductory period ends, the ARM begins resetting at regular intervals. For example, after five years, the introductory period of a 5/1 ARM expires and the loan's interest rate will reset annually.
Index. Adjustments to ARM loans are tied to movements in financial markets and the values of certain indexes, which are widely published. Many ARMs, for example, are based on the London Interbank Offered Rate, or LIBOR. When it's time for the loan's rate to reset, the value of the index is added to another component, the margin, to create what's called a fully-indexed rate.
Margin. The margin is set by the lender and agreed to by the borrower. It's a percentage, for example, 2.5 percent, that's added to the value of the loan's index to come up with the fully-indexed rate.
Fully-indexed rate. This is the rate calculated when an ARM resets. It is determined by taking the value of the loan's index and adding its margin. For example, if a loan based on the LIBOR index is adjusting in September 2014 and has a margin of 3.00 percent, its new rate equals 3.58 percent, because the value of the 1-year LIBOR at that time is .58 percent. However, that rate is subject to restrictions -- caps and floors.
Lifetime cap, or ceiling. Almost all ARMs have caps which limit how high a rate can go during the loan's term, regardless of what happens in financial markets or what the loan's fully-indexed rate is. The cap can be expressed as a maximum interest rate or a maximum increase over the start rate (usually five or six percent). For example, a 5/1 ARM might start at 3.00 percent and have a ceiling of 9.00 percent (or six percent over its start rate).
Adjustment caps. ARM loans can have more than one type of cap. The initial adjustment cap limits the first rate adjustment. It may be expressed as an interest rate or a maximum increase. A 5/1 ARM might have an initial adjustment cap of three percent. The periodic adjustment cap is usually lower than the initial adjustment cap. The typical cap for a 5/1 ARM is two percent per year.
Rate floor. This is the lowest rate the loan can have, regardless of what happens in financial markets or what the loan's fully-indexed rate is.