Adjustable Rate Mortgages (ARM) are loans whose interest rate can vary during the loan's term. These loans usually have a fixed interest rate for an initial period of time and then adjust based on market conditions. The initial rate on an ARM is lower than on a fixed rate mortgage which allows you to afford and hence purchase a more expensive home. Adjustable rate mortgages are usually amortized over a period of 30 years with the initial rate being fixed for anywhere from 1 month to 10 years. After initial fixed rate period, your rate will be adjusted based on "margin" plus "index". Margin is a constant which will not change over the loan term. Margin is determined by lender and reflects lender's risk premium for doing this type of loans. Index is a variable selected by lender and reflects lender's cost of fund. Index serves as the financial instrument the ARM loan is tied to such as: 1-Year Treasury Security, LIBOR (London Interbank Offered Rate), Prime, 6-Month Certificate of Deposit (CD) and the 11th District Cost of Funds (COFI). Rate = Margin + Index. When index changes, rate will change.
The most popular type of adjustable-rate mortgage today is Hybrid ARM, which is the mix of fixed rate and adjustable rate. Typical Hybrid ARMs are 3/1, 5/1, 7/1 and 10/1 ARM. The rates for these hybrid ARMs are fixed for initial 3, 5, 7 or 10 years and monthly payments are amortized over 30 years. After initial 3, 5, 7 or 10 years fixed rate period, your rate will be reset once a year and your minimum monthly payment will be adjusted every 12 months as well according to the loan balance, remaing term and interest rate at that time.
When the time comes for the ARM to adjust, the margin will be added to the index and typically rounded to the nearest 1/8 of one percent to arrive at the new interest rate. That rate will then be fixed for the next adjustment period. This adjustment can occur every year, but there are factors limiting how much the rates can adjust. These factors are called "caps". Suppose you had a "3/1 ARM" with an initial cap of 2%, a lifetime cap of 6%, and initial interest rate of 4.25%. The highest rate you could have in the fourth year would be 6.25%, and the highest rate you could have during the life of the loan would be 10.25%. Most of ARMs also have a 2% periodic cap which means maximum rate adjustment every year after initial fixed rate period is 2%. For example 3/1 ARM, if fourth year rate is 6.25%, fifth year rate can not be more than 8.25% or lower than 4.25% due to 2% periodic cap. An ARM loan also has an interest rate floor meaning the lowest rate you may pay during the life of the loan. The floor is the margin. In case of negative interest rate environment, your lowest rate could equal to margin.
The beauty of a Hybrid ARM is that the initial interest rate for the fixed period of the loan is lower than the rate would be on a mortgage that's fixed for 30 years. Hence you can enjoy a lower rate while having period of stability for your payments. You can also refinance as the initial fixed rate period expires. By getting a lower rate and lower monthly payments than with a 30 year fixed rate loan, you can break even more quickly on refinancing costs, such as title insurance and the appraisal fee.
Advantages:
Feature lower rates and lower monthly payments during initial period of the loan term.
Allow borrowers to take advantage of falling rates without refinancing.
Best for homeowners who will not stay in the house or hold the mortgage for long run
Build equity faster due to lower rate during early stage of the loan
Disadvantages:
Rates and payments might rise significantly over the life of the loan.
Interest rate structures are more complicated
More difficult to budget accurately
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