Adjustable Rate Mortgage (ARM)

Question: What is an Adjustable Rate Mortgage (ARM)?

Answer: An adjustable rate mortgage is a loan program that is set up to make it easier for borrowers to purchase property by offering a lower introductory rate of interest. The interest rate then makes an adjustment periodically. The adjustment can make the monthly payments go up or down during the life of the loan.

Question: How does an adjustable rate mortgage work?

Answer: The starting rate (called a teaser rate) is usually about 2% less than the standard fixed conventional rate. Adjustable rate mortgages are tied to financial indexes or benchmarks that are computed on a particular index and a margin.

• Example: If the index level is at 5% and the margin is at 2%, the total rate will be 7%. If the index level rises to 6%, the margin stays the same and the total rate goes up to 8%.

Question: What dictates the index level?

Answer: There are certain indexes that lenders normally use when determining the rate of interest that will be charged, like the ones listed below.

• The Federal Home Loan Bank of San Francisco publishes the 11th District Cost of Funds Index that is used nationwide. This index reflects the borrowing costs of around 200 banks and savings and loans in Arizona, California, and Nevada and is regarded as the most stable index.
• The London Interbank Offer Rate (LIBOR) is sometimes used as an index based on the borrowing cost of 5 major British lenders.
• 6 month, 1 year, 3 year, and 5 year Treasury Securities are used as a floating average to determine moderate interest rates.

Question: How long does it take before the payments start to adjust?

Answer: Sometimes it may take a year or more before the payments move at all but in most cases, the payments make an adjustment, usually upwards, within the first 6 months.

Question: How many times a year does the payments adjust?

Answer: Most adjustable rate mortgages adjust 2 times a year but some may adjust monthly, once a year, and some adjust once every 2, 3, or 4 years.

Question: Is there a limit on how much the rate can go up in a given time frame?

Answer: There will be what is called "a rate cap" on most adjustable rate mortgages. The rate cap controls the number of times the rate can go up, or down, within a specified period of time.

Question: Is there a cap on how high the interest can go up over the life of the loan?

Answer: Most adjustable rate mortgages have a cap on how much the interest rate increases over the life of the loan, usually 5 or 6 percentage points above the initial teaser rate. There may also be cap on how low the rate can go down.

Question: If interest rates go up or down, will my monthly payment automatically go up or down?

Answer: Not necessarily. Payment changes may be restricted to once a year, even if the interest rates change more often than that during that same period of time.

Finance Topic of the Month: Managing Money