Mortgages Explained: How a Typical ARM Mortgage Works

by Mortgage Nerd on September 6, 2012 · 0 comments

The ARM, or Adjustable Rate Mortgage can be a great strategy for the right situation. For example it can make sense in a situation where the homeowner isn’t going to live in the home for longer than the fixed rate period.  I will discuss a few situations when the ARM can make sense, but first lets talk about the mecanics of a typical conventional ARM…

For how many years is the Adjustable Rate Mortgage fixed? Most lenders will offer a 1/1, 3/1, 5/1, 7/1, and 10/1 ARM. The first number refers to the number of years that the interest rate is fixed and the second number (1) refers to 1 term in which the interest rate is adjustable. For example, on a 7/1 ARM, the interest rate is fixed for 7 years and the remaining 23 years the interest rate will be adjustable. (A typical ARM is a 30 year mortgage)

How often will the interest rate adjust and how is the rate determined? The interest rate will adjust every year, once a year. The rate will be determined by an economic index plus a margin.  The 1 year LIBOR, or the London Interbank Offer Rate (I think), is a very common interest rate used for determining the rate on adjustable rate mortgages.  The lender will take that rate and add a margin (think of “margin” as the bank’s profit) of anywhere between 2 and 3%. Right now, the lender that I work for adds a margin of 2.25%. This margin can NOT change during the life of the loan. FYI, the 1 year LIBOR is currently at 1.04% and so people that got a 7 year ARM 7 years ago, are now getting a rate around 3.375% (it always rounds up to the nearest .125%). To get a feel for how the 1 year LIBOR has moved over the past 20 years, you can do a google search for history of 1 year LIBOR.

Why would I choose an ARM when I can get a 30 year fixed?  This is obviously a very valid question but the truth is that you pay a premium to get a 30 year fixed mortgage.  For example at my company a client can get a 7/1 ARM at about 2.875% when the 30 year fixed is at 3.625%. If you plan on staying in your home for more than 7 years than you are probably better off going with the 30 year fixed.  But if you are like many homeowners who move about every 7 years, than the 7/1 ARM can be a great strategy to save a lot of money in interest.

What are the risks of an ARM? In my experience as a loan officer there are a lot of misconceptions about adjustable rate mortgages. Many people believe that once the fixed period expires that the bank has the right to raise their interest rate and payments to wherever they like. Others believe that the interest rate and payment has to go up. This just isn’t true. Like previously said in this article, the interest rate will be determined by the sum of the 1 year LIBOR plus a margin of around 2.25.  Also, it is important to note that there are certain caps in place to protect the borrower against obscene increases in rate or payment.

What are the typical caps on an ARM?  The lifetime cap on a typical ARM is 5% over the start rate. This means that if the fixed rate period on a 7 year ARM is 2.875% that the interest rate could never adjust higher than 7.875%, regardless of what the 1 year LIBOR does. Also, there is a yearly cap of 2%, meaning the rate can’t change by more than 2% from one year to the next, up or down. This applies to every adjustment except the first one, when the rate can adjust to the maximum, if that is what the 1 year LIBOR and the margin equates to.

I think the media has demonized this loan product when in all reality it can be a great strategy to saving some m0ney. It’s not for everyone but for a first time homebuyer who is certain that they won’t be in their home for a very long time, it can make a lot of sense.

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