Adjustable Rate Mortgage

Adjustable Rate Mortgages (ARM)s are loans whose interest rate changes during the loan's term. These loans usually have a fixed interest rate for an initial period and then can adjust based on market conditions. The initial rate on an ARM is most often lower than on a fixed rate mortgage which allows you to afford a more expensive home. ARMs are usually amortized over a period of 30 years with the initial rate being fixed for anywhere between 1 month to 10 years. All ARM loans have a margin plus an index. Margins on ARMs typically range from 1.75% to 3.5% depending on the index used and the amount financed as it relates to the property value. The index is the financial instrument that the ARM loan is tied to such as: Prime, LIBOR (London Interbank Offered Rate), 1-Year Treasury Security, 6-Month Certificate of Deposit and the 11th District Cost of Funds (COFI).

When the adjustment period for the ARM begins, the margin will be added to the index 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 "5/1 ARM" with an initial cap of 2%, a lifetime cap of 5%, and initial interest rate of 5.25%. The highest rate you could have in the fourth year would be 7.25%, and the highest rate you could have during the life of the loan would be 10.25%.