The Definition of Adjustable Rate Mortgage

My adjustable rate mortage runs out in within the next few months. What happens at that time with my present mortgage holder?

1 Answer

An Adjustable Rate Mortgage (ARM) is based on an initial fixed period, followed by an adjustable period for the remainder of the loan. This is typically noted as X/Y with X being the initial fixed term, and Y being the period of adjustment after the fixed term. For example 5/1 would represent a loan with an initial fixed rate for the first 5 years. After that the rate would adjust each year (the 1 of the 5/1 equation). Additionally, each loan has an amortization period. This is the period of time over which the loan will amortize itself, or pay itself off. These are normally 30 years, although it is possible to obtain a shorter term. In the case of a 5/1 ARM with a 30 year amortization, the loan would operate like this:

For the first 5 years, your rate would be fixed at the initial interest rate obtained at signing. After that the interest rate on the loan (and therefore the payment) would adjust every year, for the remainder of the 30 years of the loan. In this case, for the last 25 years, since you had a fixed interest rate for the first 5. You can always pay a loan off early, or refinance, so it is not required that you have the loan for the entire 30 years, but if you did, each year after year 5 you would have a new interest rate.

As for what the interest rate would be once it begins to adjust, I'll explain how they are calculated. The initial interest rate of your ARM loan has no bearing on future rates, it is simply a rate that was agreed upon at the time of closing. Shortly before your initial adjustment (normally a month or two) you will receive notification of your new rate. This new rate is based off of 4 factors that are in your initial loan agreement, typically in a document called an Adjustable Rate Rider. 1.) Your index. This is the portion of your ARM that will adjust. The specific index on your loan will be outlined in your ARM rider. Popular indices include a 6 month LIBOR, Prime Rate, or a 1 year Treasury. These indices will move depending on the overall economy, either up or down. At the time of your adjustment, they are the first step to obtaining your new rate.

2.) Your margin. Your margin is a fixed percentage that is added to your index to obtain your new rate. The margin is also listed in your ARM rider. Essentially the lender will take the current index on the given day stated for adjustment, and add the margin to it. Simply put, this is your new rate. There are 2 caveats to this formula, which are the next 2 factors.

3. and 4.) Adjustment and Life Caps. These are caps on how quickly and how far the interest rate may rise and fall. An adjustment cap is normally around 2%, but your specific cap will be spelled out in your rider. For example purposes, lets say your initial rate was 5%. At the time of adjustment lets say that the index is 4% and your margin is 3.5%, adding those two together would result in a rate of 7.5%. If you had a 2% adjustment cap however, that would mean your rate could not change more than 2% either up or down in any one adjustment period. Because 7.5% is 2.5% higher than your initial rate of 5, your new rate would be capped at 7%.  A life cap is similar, as it states what the minimum and maximum rates can be on your ARM over the entire life of the loan. In this way, you can know that regardless of what happens with the index and margin your rate can never be higher that X, or lower than X, depending on what is specifically spelled out in your agreement.

While no one can tell you what will happen in the future, it is important to review the terms of your ARM before signing to make certain that they 4 factors that will control your interest rate are all acceptable to you.