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What Are Adjustable Rate Mortgages (ARMs)
How does adjustable rate mortgages work? What are the three numbers X/X/X on ARMs? Can someone help me with this question about adjustable rate mortgages?
Matt has obtained a 30-year 3/1 ARM mortgage loan for $150,000 on a beautiful four-bedroom two bath home in the suburbs. The start rate was 3%. The rate caps are 4/2/8. The margin is 3%. The index was 4% at the start of the loan, 4.25% at the end of year three, and 6.5% at the end of year four. Which of the following rates would reflect the interest rate that will begin in year number five?
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2 Replies
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An adjustable-rate mortgage (ARM) is a type of home loan where the interest rate can fluctuate over the life of the loan. Here’s how ARMs typically work:
Initial Fixed-Rate Period ARMs usually start with a fixed interest rate for an initial period, such as 3, 5, 7, or 10 years. During this time, your monthly mortgage payment remains the same.
Index and Margin After the fixed-rate period ends, the interest rate becomes adjustable and is tied to a specific benchmark index, such as the Secured Overnight Financing Rate (SOFR) or the London Interbank Offered Rate (LIBOR). The lender adds a fixed margin to the index rate to determine your new interest rate.
Adjustment Periods The interest rate on an ARM is adjusted periodically, usually every 6 months or once a year, based on the movement of the index rate. Your mortgage payment will change accordingly based on the new interest rate.
Interest Rate Caps Most ARMs have caps that limit how much the interest rate can increase or decrease during each adjustment period and over the life of the loan. For example, a 5/1 ARM may have a 2% annual adjustment cap and a 5% lifetime cap over the initial fixed rate.
Conversion Option Some ARMs allow borrowers to convert the loan to a fixed-rate mortgage at certain times during the loan term, which can help avoid future rate adjustments.
The main advantage of an ARM is that it typically offers a lower initial interest rate compared to a fixed-rate mortgage. However, the trade-off is that your rate and monthly payment can increase when the fixed period ends and rates adjust.
ARMs can be beneficial for borrowers who plan to move or refinance before the fixed-rate period ends, or those who can manage potential payment increases if interest rates rise. However, they involve more risk than fixed-rate mortgages if rates climb significantly.
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Initial Rate Period: This is the initial period during which the interest rate remains fixed. It’s often denoted as a combination of a number and a letter, such as “5/1 ARM” or “7/1 ARM.” The first number represents the length of the initial fixed-rate period, usually in years, while the second number represents how often the interest rate can adjust after the initial fixed period (e.g., annually in a 1 ARM or every five years in a 5/1 ARM).
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Index: This is a benchmark interest rate that the lender uses to determine the interest rate on the ARM. Common indices include the London Interbank Offered Rate (LIBOR), the Constant Maturity Treasury (CMT), or the Cost of Funds Index (COFI). The interest rate on the ARM is typically tied to this index.
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Margin: This is a fixed percentage added to the index to determine the interest rate on the ARM. For example, if the index rate is 3% and the margin is 2%, the initial interest rate on the ARM would be 5%. The margin remains constant throughout the life of the loan but is added to the current index rate when the interest rate adjusts.
These three components together determine how the interest rate on an adjustable-rate mortgage will change over time.
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