Most mortgage applicants would prefer to have the lowest interest rate possible when they close their loan and this is only natural. In the past the best way to get the lowest rate was to obtain an Adjustable Rate Mortgage, sometimes referred to as an (ARM) loan. This has somewhat changed and is not the rule of thumb any longer. Fixed interest rates available now are just about as low as the adjustable rates were seven years ago in some instances; depending upon the term of the loan. Fixed interest rates are at the all time low but there are times when the ARM loan might be the best choice.
Adjustable rate mortgage:
A mortgage in which the interest rate is adjusted periodically according to a preselected index. The terms, adjustment schedule, and index to be used can be negotiated by the borrower and lender. Specific types include the renegotiable rate mortgage and the variable rate mortgage. This type of interest rate fluctuates at certain designated period adjustment dates and is not a fixed rate loan. Some specific types of ARM loans are fixed for the initial period and they are: 1/1, 3/1, 5/1, 7/1 and 10/1 year ARM products. The means that the rate on a 3/1 ARM will be fixed for the first 3 years and after the initial fixed term; the interest rate will begin to adjust every 12 months according to the parameters within the note and mortgage rider. The 5/1 product will flow the same way except is fixed for the first 5 years of the loan; the 7/1 and 10/1 accordingly. There is also a LIBOR ARM which changes every 6 months.
Index: A published interest rate, which lenders measure the difference between the current interest rate on an adjustable rate mortgage and that earned by other investments (such as one-, three-, and five-year U.S. Treasury security yields). There are many arm indexes which have various features and fluctuates differently. The most commonly known indices are:
Constant Maturity Treasury (CMT or TCM)
Treasury Bill (referred to as the T-Bill)
12-Month Treasury Average (MTA or MAT)
11th District Cost of Funds Index (COFI)
Certificate of Deposit Index (CODI)
Cost of Savings Index (COSI)
London Inter Bank Offering Rates (LIBOR)
Bank Prime Loan (Prime Rate)
The most frequently used are the CMT, T-Bill, COFI and LIBOR indexes. There is a lot of information about mortgage indices that should be clearly understood by anyone who is opting to close their loan with an adjustable interest rate.
Margin of the ARM loan:
The adjustable interest rate loan is also made up of the margin and this is a percentage that the lender adds to the index rate to make up the total or true interest rate. The margin can vary also, but a common margin is 2.750% and these figures are all shown on your adjustable rate note and mortgage ARM rider. These two documents should match and the mortgage ARM rider is required for all adjustable rate loans. This document is recorded with the deed of trust/mortgage document. The recording information will also be within the title policy.
Other Features of an ARM Loan
These features of an ARM loan; the periodic rate change dates, the frequency, the periodic interest rate caps, the life of loan cap (if applicable), and the payment change dates are all a very important part of the loan.
The initial rate change date can be different then the remaining periodic change dates. For instance; on a 3/1 ARM; the first interest rate change date can be 36 to 37 months or within that range from the date of the closing of the loan but, will thereafter change every 12 months. The 5/1, 7/1 etc., flow the same way. The one behind the first number means that after the initial rate adjustment; the periodic change date will be every 12 months. The payment will change the month following the interest rate change date.
Caps on the interest
The initial interest rate cap will be specified on the mortgage note and rider. This will depend upon the type of ARM. Example: the initial rate change for 5/2/5 ARM may not exceed 5 % above the start rate at the first change date. That does not mean that it will increase by 5 % but it may not exceed that %. Typically, the periodic rate change after the first change date will change no more than two (2) % and is called the periodic cap and it will not change more than 5% over the life of the loan which makes it the 5/2/5 ARM. For the 6 month LIBOR ARM loans, it is typically 1% every 6 months and 2% annually. ARM interest rates are round up or down .125%, unlike the APR of a loan.
Life of Loan Cap
The life of loan cap means that the interest rate will not change more than 5 or 6% (normally), over the initial interest rate for the entire loan term. Often the cap is specified on the note and mortgage rider as the interest rate will never be more than 10.750%. Meaning this is the highest that your rate will go over the life of the loan.
As stated ARM features depend upon the product and there are products which have not been mentioned here. ARM features are complex, diversified and the person who might consider needing an ARM loan should always receive an ARM disclosure with the features spelled out so that you understand the products.
Normally those who opt for this type of interest rate; are those who do not plan to stay in their home for a long period of time; due to relocation with their employer or someone who is interested in buying another home within 5, 10 years. There are some borrowers who opt for an ARM to get a lower payment to qualify for the loan. The latter option is not considered the wisest choice. ARM loans will change, the rate and payments fluctuate and if the features of the product are not understood; the applicant could possible find themselves with a product they are uncomfortable with. Ask questions and seek advice.