Adjustable-Rate Mortgages (ARMS)
mortgages, or ARMS, differ from fixed-rate mortgages
in that the interest rate and monthly payment move
up and down as market interest rates fluctuate.
Most have an
initial fixed-rate period during which the
borrower's rate doesn't change, followed by a much
longer period during which the rate changes at
Adjustable Rates Start Low
during the initial periods are generally lower than
those on comparable fixed-rate mortgages. After all,
lenders have to offer something to make it worth
their while to assume the risk of higher rates in
fixed-rate period can be as short as a month or as
long as 10 years. One-year ARMS, which have their
first adjustment after one year, used to be the most
popular adjustable, and were the benchmark. Recently
the standard has become the 5/1 ARM, which has an
initial fixed-rate period that lasts five years; the
rate is adjusted annually thereafter. That type of
mortgage, which mixes a lengthy fixed period with an
even lengthier adjustable period, is known as a
hybrid. Other popular hybrid ARMS are the 3/1, the
7/1 and the 10/1.
These hybrid ARMS
-- sometimes referred to as 3/1, 5/1, 7/1 or 10/1
loans -- have fixed rates for the first three, five,
seven or 10 years, followed by rates that adjust
fixed-rate honeymoon, an ARMS rate fluctuates at the
same rate as an index spelled out in closing
documents. The lender finds out what the index value
is, adds a margin to that figure and recalculates
the borrower's new rate and payment. The process
repeats each time an adjustment date rolls around.
Most ARM rates
are tied to the performance of one of three major
constant maturity yield on the one-year Treasury
The yield debt
securities issued by the U.S. Treasury are paying,
as tracked by the Federal Reserve Board.
2. 11th District
Cost of Funds Index (COFI)
financial institutions in the western U.S. are
paying on deposits they hold.
Interbank Offered Rate (LIBOR)
The rate most
international banks are charging each other on large
Not the Limit
some protection from extreme changes because ARMS
come with caps. These caps limit the amount by which
ARM rates and payments can adjust.
Caps come in a
couple of different forms. The most common are:
1. Periodic rate
cap: Limits how much the rate can change at any one
time. These are usually annual caps, or caps that
prevent the rate from rising more than a certain
number of percentage points in any given year.
2. Lifetime cap:
Limits how much the interest rate can rise over the
life of the loan.
3. Payment cap:
Offered on some ARMS. It limits the amount the
monthly payment can rise over the life of the loan
in dollars, rather than how much the rate can change
in percentage points.
Around the turn
of the 21st century, lenders began to market
interest-only mortgages to middle-class borrowers.
Formerly the preserve of what lenders called
"affluent clients," interest-only mortgages are
usually adjustable. The borrower is required to pay
only the interest for a specified period, often 10
years. After that, it adjusts to the going interest
rate, as tracked by a specified index. After that,
the loan amortizes at an accelerated rate. During
the interest-only period, the borrower can choose to
pay some principal, too. By providing flexibility in
the size of monthly payments, interest-only
mortgages often are a good match for people with
fluctuating monthly incomes: salespeople who are
paid by commission, for example.
Some ARMS come
with a conversion feature that allows borrowers to
convert their loans to fixed-rate mortgages for a
fee. Others allow borrowers to make interest-only
payments for a portion of their loan terms to keep
their payments low. But no matter the exact terms,
most ARMS are more difficult to understand than
To keep your
financial options open, make sure to ask the
mortgage lender if the ARM is convertible to a
fixed-rate mortgage. Also, ask if the ARM is
assumable, which means when you sell your home the
buyer may qualify to assume your existing mortgage.
That could be desirable if mortgage interest rates
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