Referred to as ARMs, these loans are fixed only for a short period of time, typically 6 months to 10 years. They will be amortized over a 30 year term. ARMs will have lower start rates than fixed rate mortgages, but will adjust to current market rates when the fixed period has expired.
Fixed Period – Most ARMs have initial period in which the rate and payments are fixed. This period could last for 1 year, 3 years, 5 years, 7 years, or even 10 years. The rate will not change during the fixed period, but may change when that period ends.
Adjustment Period – After the fixed period of an ARM ends, the interest rate will adjust periodically at a set time, usually every 12 months.
Index – The changes in rate on an ARM are based on an index. This index could be the 1 year Treasury index, the LIBOR, or a Cost of Funds Index specific to the bank. The index is used to determine the note rate only at the time of the adjustment, not during the fixed period. If the index rate goes up, then your payment may go up as well. Consequently, if the index drops, your payment may go down. Current indices such as the T-Bill and LIBOR can be found in the Wall Street Journal.
Margin – At the time of the adjustments, the bank will add a predetermined amount to the index to arrive at your new rate. When shopping for ARM rates, be sure to compare margins as well. For example, if two lenders are using the same index but Bank A has a higher margin than Bank B, you will pay a higher interest rate in the future with Bank A.
Caps – Interest rate caps limit the amount that your ARM rate can increase or decrease. There are two kinds of caps:
- periodic caps, which limit the amount of movement from one period to another
- lifetime caps, which limit the increases in rates for the life of the loan.