An adjustable-rate mortgage, or ARM, has an introductory interest rate that stays the same for 3,5,7 or 10 years and adjusts every year after that for the remaining period. See how it works below.
The "1" after 10/1, 7/1, 5/1, 3/1 indicates that the interest rate is subject to an adjustment once per year after the initial fixed period.
-The interest rates for adjustable rate mortgages during the fixed period are usually lower than a fixed rate mortgage, which means you'll have a lower monthly payment.
This also means you should be able to qualify to purchase a home with a higher price than with a fixed-rate mortgage.
It is an advantageous loan product, if you only plan to move or sell your home prior to your first adjustment period. With either the 5-, 7- or 10-year ARMs, you'll receive the lowest interest rate available and save thousands compared to the standard fixed-rate mortgage through the initial fixed-rate period.
Are you aware that most people stay in their home for 7-8 years now?
Examples of ARM Loan Calculation
Let's say you obtain rate quotes from two different companies, for a 5/1 adjustable-rate mortgage. Both companies use the same index for ARM calculation, but their margins vary. The margin is their profit.
• Mortgage Company "A" uses the 1- year Treasury index plus a 2.25% margin.
• Mortgage Company "B" uses the 1-year Libor index plus a 3.00% margin. Here’s how the rate would be calculated in these scenarios:
• Company "A" offers you an ARM loan of 2.25% (based on the 1-year Treasury index) plus their 2% margin. In this scenario, your initial ARM rate would be calculated as 4.25%.
• Company "B" uses the 1-year Libor index of 2.25%, but they add a higher margin of 3%. So the interest rate on your ARM loan would be 5.25%. Remember, the index can change over time ot the margin. Some indexes move slower than others.
An interest-only IO ARM allows you to pay only interest on your mortgage for a set number of years, normally between 5 and 10. Your principal loan balance will stay the same since you are only paying interest only.
Once the interest only period is over your payments will become much bigger, because it will be calculated using principal and interest but based on the remaining term.
Is there a maximum interest rate for an Adjustable Rate Mortgage?
Yes, adjustable rate mortgages have three rate caps that restrict how much your interest rate can change. One cap restricts the amount the interest rate can change on the first adjustment date (3,5,7 or 10 years), the second restricts the amount the interest rate can change every adjustment period after the first adjustment period, and the third cap restricts the maximum interest rate you can pay for as long as you have the mortgage.
The typical rate cap is 2/2/5 or 2/2/6. Here’s an example of how this works. Let's say that you have a 7/1 ARM with an initial rate of 4.75% and a 2/2/6 rate cap structure. For the first seven years your rate would be 4.75%. Because the initial adjustment cap is 2%, for your 8th year, your rate could go up to as much as 6.75% (4.75% initial rate plus 2% adjustment cap equals 6.75%). This does not mean that the rate will go up to 6% -- it might stay the same or go up just a little bit.
After the eighth year and every year thereafter, the rate could go up as much as 2% (the periodic cap). However, because the lifetime cap is 6%, the rate could never go over 10.75% (4.75% initial rate plus 6% lifetime cap equals 10.75%). Again, this doesn't mean that the rate will go up to 10%, only that it can.