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Adjustable-rate mortgages (ARMs) are loans
that vary in interest rate and payment periodically to
adjust toward the prevailing market after an initial
fixed period of time. ARMs have several characteristics
that determine your Interest Rate including the Index,
Margin, Caps, Fixed Period, and Adjustment Period.
The Fixed Period of an
ARM is the initial period of time which your Interest
Rate will remain fixed. The Adjustment Period of an ARM
is the regular period of time which the Interest Rate
will adjust toward the prevailing market after the Fixed
Period has expired. The most popular ARMs are the 3/1
ARM, 5/1 ARM, and 7/1 ARM, and they are amortized over
30 years. The 3/1 ARM has a fixed interest rate and
monthly payments for three (3) years. On the third
anniversary of the loan, the interest rate will adjust
towards the prevailing market once every one (1) year on
the same date. The interest rate that you pay on one of
these ARMs will typically be much less comparable to the
30-year Fixed. It is important to note that the shorter
the Fixed Period of the ARM the lower the initial fixed
Interest Rate. After the initial Fixed Period, the
Interest Rate is calculated and adjusted as described
below.
The Index is the
adjustable factor of the loan and are posted
continuously in financial papers and online resources.
More stable indices command higher margins. Typical
indices are the One-Year Treasury, 6 Month LIBOR Rate,
and 11th District Cost of Funds Index (a.k.a. COFI and
pronounced “coffee”).
The Margin is a
fixed-rate characteristic of the ARMs that, when added
to the Index rate, determines your Interest Rate. For
example, an ARM based on the 6 Month LIBOR Index at
1.25% with a Margin of 2.5% yields an Interest Rate of
3.75%. It is important to note that a longer Adjustment
Period on the ARM correlates to a higher Margin.
There are Caps built in
to most ARMs so that your Interest Rate cannot increase
or decrease too dramatically over time. The Adjustment
Cap is the maximum change in Interest Rate allowed at
any adjustment point. Typically this is set to 2%
allowable change. The Lifetime Cap is the maximum upward
change in Interest Rate allowed from the initial
Interest Rate. Typically the Lifetime Cap is set to 6%
maximum change upward.
For example, consider a
3/1 ARM based on the 6-Month LIBOR with a Margin of 2.5%
and an initial Interest Rate of 3.75%, 2% Adjustment
Cap, 6% Lifetime Cap. At no point in the life of the
loan may the Interest Rate rise above 9.75% (Initial
Interest Rate of 3.75% + Lifetime Cap of 6%). If after 3
year fixed period the 6-Month LIBOR Index is 3.5%,
calculating the new Interest Rate would yield 6% (Index
of 3.5% + Margin of 2.5%). BUT, the new Interest Rate
would actually be 5.75% because of the 2% restriction of
the Adjustment Cap (Initial Interest Rate of 3.75% +
Adjustment Cap of 2%).
An important factor to
recognize when choosing an ARM: If you sell your home or
obtain a new loan within the next 3 years, choosing a
3/1 ARM will potentially save you thousands of dollars
over the next 3 years compared to a 30-year Fixed
mortgage, and you will would not have had to deal with
any adjustments.
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