What Is an Adjustable Rate Mortgage (ARM)
An adjustable rate mortgage is a type of mortgage in which the interest rate on the loan balance changes throughout the life of the loan. The interest rate is usually fixed for a specific amount of time and is periodically reset often yearly. The new interest rate is based on a benchmark called an ARM margin.
Understanding Adjustable Rate Mortgages – ARM
Typically, ARMs are expressed as two numbers. The first number is the length of time the fixed rate is applied to the loan, but the second number can vary. For example, a 2/28 ARM features a fixed rate for two years, followed by a floating rate for 28 years. In contrast, a 5/5 ARM is a fixed rate for five years and then adjusts every five years after. To the contrary, a 5/6 ARM has a fixed rate for five years, then adjusts every six months.
What are Indexes and Margins
At the end of the fixed rate period, ARM interest rates can either increase or decrease based on an index plus a set margin. Although the index rate can change, the margin stays the same. For example, if the index is 5% and the margin is 2%, the interest rate on the mortgage will adjust to 7%. Conversely, if the index is 2% and the margin is 2%, the interest rate on the mortgage will adjust to 4%.
What Are Rate Caps on ARMs?
Most ARMs come with rate caps that limit how high the rate can be or how much the monthly payments can change. Periodic rate caps limit how much the interest rate can change from year to year. Lifetime caps set limits on how much the interest can increase over the entire life of the loan. Payment caps limit how high the monthly mortgage payment can be.