Adjustable rate mortgage is a type of loan where the initial interest rate is fixed for a certain time, then varies periodically based on the terms of the loan chosen by the borrower and the benchmark interest rate chosen by the lender. For example, 5/1 ARM has an initial interest set for first 5 years, then the interest changes annually. Fixed rate mortgages have a same interest rate over the life of the loan, adjustable rate mortgages usually have lower interest rates initially and then adjusts periodically according to the terms of the loan.
Components of an ARM loan
Index - It is a financial indicator that rises and falls depending on the fluctuations in the economy. This is the basis of all the future adjustments
Margin - The margin is usually added to the index because index represents the cost of funds and margin represents the lender's cost of business and profit.
Adjustment Period - This is the period in which the interest rate is scheduled to change during the life of the loan. typically, the change is annual.
Interest rate cap - This is a limit placed on the up and down movement of the interest rate specified per period adjustment and lifetime adjustment.
Negative Amortization - It occurs when the monthly mortgage payments are not even enough to cover the interest rate and the amount gets added on to the principal, thus increasing the loan amount.
Conversion option - This is an option to convert an ARM loan into a fixed rate loan, conversion fee may be charged.
Types of ARM loan
ARM loans are generally classified as Hybrid ARM, Interest only option and Payment option.
Hybrid ARMs offer a mix of fixed and adjustable rate period where the interest rate is usually fixed at the beginning and fluctuate according to the terms of the loan. This is usually represented in two numbers where the first number represents the length of the interest rate on the fixed period of the loan and the second number represents the time period or the frequency of the adjustable variable rate.
For example, 5/1 ARM represents a fixed interest rate for the first five years and then the interest rate fluctuates every year.
Interest only ARM
An Interest only loan is a type of loan where you pay mortgage payments only on the interest for a specified amount of time instead of making payments on both interest and principal. These are usually considered as a non qualified mortgage. The principal amount of the loan remains unchanged during the term as there is no amortization of the principal during the loan period. Usually, the interest only loan is structured as an adjustable rate mortgage called as Interest only ARM. The principal amount is paid either as a lump sum or as a subsequent payment method. The loan can be changed to either conventional or balloon payment at the end of the interest only loan period. The interest only loan period could be anywhere between 5 -10 years on a 30 year loan.
Payment Option ARM
Payment option is a flexible payment plan where the borrower may decide to pay both the interest and principal or only the interest or only a part of interest. Paying only the part of interest results in negative amortization. Negative amortization results in gradual increase in the principal amount which might result in borrower making a lump amount like a balloon payment at the end of the loan term.
Pros of Adjustable Rate Mortgage
The interest rates are usually lower than the interest rate on the fixed rate mortgages. In 5/1 ARM, the interest rate is locked down for the first 5 years to a lower rate.
If you are buying a home for a short period of time and then planning to sell or move, then ARM loan may be the best suit for you.
The mortgage payments may decrease if the interest rate falls and drives down the index.
Some ARM loans include a prepayment penalty, this is a fee that may be charged while selling or refinancing your home within a specific time period.
It is very important to be aware of all the rules, penalties and structures of the loan and may cause a risk if not properly understood.