Because lenders are allowed to adjust an ARM's interest rate if financial markets change, it's a safer loan for them. However, fixed rate loans are safer for borrowers -- so to convince borrowers to choose ARM products, lenders offer them at lower interest rates. Those lower rates provide ARMs with a significant advantage.
Advantages of ARM Loans
Adjustable rate mortgages have some unique selling points.
- Lower interest rates (at least during their introductory periods)
- Start rates can be fixed for up to ten years, making them fairly safe
- If rates fall, borrowers can get a lower rate without refinancing
- Lower payments can help borrowers manage their cash flow better
Disadvantages of ARM Loans
The chief disadvantage of an adjustable rate mortgage is that its rate can adjust upward once its introductory period ends. How that rate changes is specified in the terms of the ARM, which are established by the lender and agreed to by the borrower.
Important Components of ARM Loans
Here's a list of the most common elements of ARM loans. Borrowers should understand them 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. 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 maximum rate cap of 9.00 percent (or six percent over its start rate).
- Initial adjustment cap. 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.
- Periodic adjustment cap. ARM loans have another cap to keep regularly-scheduled rate resets manageable for borrowers. 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.
Types of ARMs
ARMs are known by their indexes, the introductory period, and the adjustment period. For example, a 3/1 LIBOR ARM is based on the LIBOR index, has a three-year introductory period and resets every year after that. There are many adjustable-rate mortgage products, for example:
1-month COFI ARM: First adjustment after one month, then adjusts monthly. Based on the Cost of Funds Index, or COFI.
6-month COFI ARM: First adjustment after six months, then adjusts every six months. Based on the Cost of Funds Index, or COFI.
1-year Treasury ARM: First adjustment after one year, then adjusts annually. Based on the 1-year Constant Maturity Index (CMT).
3/1 LIBOR ARM: First adjustment after three years, then adjusts annually. Based on the London Interbank Offered Rate (LIBOR).
5/1 LIBOR ARM: First adjustment after five years, then adjusts annually. Based on the London Interbank Offered Rate (LIBOR).
5/5 LIBOR ARM: First adjustment after five years, then adjusts every five years. Based on the London Interbank Offered Rate (LIBOR).
5/6 COFI ARM: First adjustment after five years, then adjusts every six months, Based on the Cost of Funds Index, or COFI.
7/1 MTA ARM: First adjustment after seven years, then adjusts annually. Based on the 12 month Treasury Average (MTA).
10/1 MTA ARM: First adjustment after 10 years, then adjusts annually. Based on the 12 month Treasury Average (MTA).