Adjustable-Rate Mortgage (ARM)
Definition
An Adjustable-Rate Mortgage (ARM) is a home loan with an interest rate that can change periodically, typically in relation to an index, and as a result, monthly payments can increase or decrease over time. ARMs usually start with a lower interest rate compared to fixed-rate mortgages, making them attractive to consumers who plan to sell or refinance before the adjustment takes place.
Key Characteristics
- Initial Interest Rate: Generally lower than fixed-rate mortgages.
- Adjustment Period: The interval at which the interest rate changes, such as annually.
- Index: The benchmark interest rate that determines the adjustment (e.g., LIBOR or Treasury Index).
- Margin: The number of percentage points added to the index by the lender to determine the interest rate.
- Caps: Limits on how much the interest rate can increase or decrease during each adjustment period and over the life of the loan.
Examples
Example 1: 5/1 ARM
A 5/1 ARM features a fixed interest rate for the first five years, followed by annual adjustments. If the initial rate is 3%, this rate remains for five years. After five years, the rate adjusts based on the chosen index plus a margin, subject to rate caps.
Example 2: 3/1 ARM
In this 3/1 ARM example, the interest rate is fixed for three years and then adjusts every year thereafter. This type often has similar rate cap structures and utilizes indices such as the 1-Year Treasury or the LIBOR.
Frequently Asked Questions (FAQs)
Q: How do rate caps work?
A: Rate caps limit how much the interest rate can change during any adjustment period (periodic cap) and over the life of the loan (lifetime cap). For example, an ARM may have a 2% periodic cap and a 5% lifetime cap.
Q: What is a payment cap?
A: A payment cap limits how much the monthly payment can increase during an adjustment period but may result in negative amortization if not managed well.
Q: What happens if interest rates go down?
A: If interest rates decline, the adjustable rate on your mortgage may decrease, which can lower your monthly payment during the adjustment period.
Q: Are ARMs only for those planning to sell or refinance soon?
A: While ARMs can benefit those who plan to sell or refinance before the rate adjustment, they also offer potential savings to other borrowers, depending on future interest rates and individual circumstances.
- Fixed-Rate Mortgage (FRM): A mortgage with an interest rate that remains the same throughout the loan term, offering predictable monthly payments.
- Cap Structure: Defines the limits on how much interest rates or payments can change.
- LIBOR (London Interbank Offered Rate): A common benchmark interest rate used to determine adjustments on ARMs.
- Index: A financial indicator used to adjust the interest rates on ARMs (e.g., Treasury Index, LIBOR).
- Negative Amortization: Occurs when the mortgage payment is not enough to cover the interest expense, causing the loan balance to increase.
Online Resources
References
- Consumer Financial Protection Bureau (CFPB). Adjustable-Rate Mortgages: Understanding the Basics. Available from: CFPB.
- Investopedia Staff. Adjustable-Rate Mortgage (ARM). Investopedia. Available at: Investopedia ARM.
Suggested Books for Further Studies
- “The Mortgage Encyclopedia: The Authoritative Guide to Mortgage Programs, Practices, Prices, and Pitfalls, Second Edition” by Jack Guttentag.
- “Home Buying Kit For Dummies” by Eric Tyson and Ray Brown.
- “Your Guide to Understanding and Getting a Mortgage” by Ryan Fischer.
Real Estate Basics: Adjustable-Rate Mortgage (ARM) Fundamentals Quiz
### What is characteristic of an initial interest rate in an ARM?
- [x] It is generally lower than that of a fixed-rate mortgage.
- [ ] It remains the same throughout the term of the loan.
- [ ] It increases every year.
- [ ] It is partly subsidized by the lender.
> **Explanation:** The initial interest rate of an ARM is generally lower than that of a fixed-rate mortgage, offering potentially significant short-term savings.
### How frequently do 5/1 ARMs adjust after the initial period?
- [x] Annually
- [ ] Monthly
- [ ] Every five years
- [ ] Never
> **Explanation:** After the initial fixed period of five years, a 5/1 ARM adjusts annually based on the agreed index and margin.
### What index might be used to determine the adjustments for an ARM?
- [ ] Dow Jones Industrial Average
- [x] LIBOR
- [ ] S&P 500
- [ ] FDIC Prime Rate
> **Explanation:** LIBOR (London Interbank Offered Rate) is a common benchmark interest rate used as an index to determine adjustments for ARMs.
### What is a periodic cap regarding an ARM?
- [ ] A limit on the house price appreciation.
- [ ] A fixed monthly mortgage payment.
- [x] A limit on the interest rate changes during an adjustment period.
- [ ] A maximum limit on annual property taxes.
> **Explanation:** A periodic cap limits the amount by which the interest rate can change during each adjustment period to protect the borrower from significant increases.
### What is the goal of a payment cap in an ARM?
- [ ] To always decrease the property value.
- [ ] To cap the origination fees for the loan.
- [x] To limit how much the monthly mortgage payment can increase.
- [ ] To mandate an annual property appraisal.
> **Explanation:** A payment cap limits how much the monthly mortgage payment can increase during an adjustment period, although it might result in negative amortization.
### When is negative amortization likely to occur?
- [x] When the mortgage payment is less than the interest accrued.
- [ ] When the property value depreciates rapidly.
- [ ] When refinancing at a lower rate.
- [ ] When the initial interest rate is high.
> **Explanation:** Negative amortization occurs if the mortgage payment is not sufficient to cover the interest due, resulting in an increasing loan balance.
### What advantage does an ARM provide regarding initial monthly payments?
- [ ] Fixed monthly payments indefinitely.
- [x] Lower initial monthly payments.
- [ ] Zero monthly payments for the first year.
- [ ] Constant principal reductions.
> **Explanation:** An ARM provides the advantage of lower initial monthly payments compared to a fixed-rate mortgage, which can be beneficial for short-term scenarios.
### What determines the updated rate for an ARM after the initial period?
- [ ] Local real estate market conditions.
- [x] The agreed upon index and margin.
- [ ] Borrower’s new credit score.
- [ ] Global oil prices.
> **Explanation:** The rate is updated based on the agreed upon index (such as LIBOR) and a fixed margin specified by the loan agreement.
### How does a lifetime cap benefit a borrower with an ARM?
- [x] By limiting the maximum interest rate increase over the life of the loan.
- [ ] By eliminating all interest costs.
- [ ] By guaranteeing a fixed rate after 10 years.
- [ ] By reducing principal more quickly.
> **Explanation:** A lifetime cap benefits the borrower by limiting how much the interest rate can increase in total, preventing uncontrolled rate increases.
### Who might be more inclined to choose an ARM?
- [ ] Someone intending to stay in the home permanently.
- [ ] Someone who fears any rate changes.
- [x] Someone planning to move or refinance before the adjustment period.
- [ ] An individual on a fixed income.
> **Explanation:** People who plan to move or refinance before the initial fixed-rate period ends might prefer an ARM due to the lower initial interest rates and potentially reduced initial costs.
