What is an ARM?

What is an ARM?

2 Answers

With regards to mortgages, " ARM" usually stands for "Adjustable Rate Mortgage". This means that the rate on the loan is not fixed for the life of the loan, but rather can change up or down according to financial markets. Adjustable rate mortgages come in all types, but generally include the following:

An "introduction" period, in which a "start rate" is used to calculate the payments. This initial period, during which the initial rate on the loan stays the same, can be as short as a month or as long as 10 years or more.

An " Index" - that is, an independent, market derived financial rate, measurement, or calculation that is driven by the external investing and not the mortgage lender itself. Common indices include the "LIBOR", or London InterBank Offered Rate, the CMT, which is an averaged yield of US treasury securities, the COFI (the cost of funds - 11th district), the CODI (an index derived from the interest paid on depository or savings accounts), Prime Rate, among others.

A fixed " Margin" - the amount that is added to the index to determine the new rate each time the rate on the loan adjusts.

Caps - the maximum amount by which the rate can change each time and over the life of the loan (used to calculate a worst case scenario).

Sometimes a "floor"  - the lowest that the rate is allowed to be no matter what the market does.

One very common ARM is the fannie mae or freddie mac 30 year conforming 5/1 LIBOR ARM, 2.25 margin with 5/2/5 caps.

This translates to: Initially the loan rate will stay the same for 5 years ("5"/1)

After the first 5 years, the loan rate will adjust one time per year (5/"1") for the remaining 25 years.

The index that will be used to determine the adjustments is the LIBOR (published in the Wall Street Journal, among other places)

The rate at adjustment each anniversary will be whatever the LIBOR is, plus 2.25% (2.25 margin)

The 5/2/5 caps mean:

The first time the rate changes (5 years into the loan), it can't change more than 5%, up or down

Each subsequent adjustment date, the rate can't change by more than 2% each time

Over the lifetime of the loan, the rate can NEVER be more than 5% more than the start rate. So, if the rate began at 4%, the rate could never be more than 9% over the life of the loan, no matter what the market does.

ARM loans often are viewed, especially by those outside of lending, as more risky than fixed rate loans due to the unpredictable nature of the payments. However, start rates are often much lower than equivalent fixed rate loans. So, potential mortgagors must weigh the value of the lower interest in the beginning against the possibility of higher rates later on. The lower the caps (FHA, for instance, has ARMS that only allow for a 1% change each time) and the longer the fixed initial period, the more predicable (and potentially safer, depending on your vantage point) the loan can be interpreted to be.

If considering an ARM, make sure that all the of the defining information above is clearly spelled out so that you can make an accurate comparison. 

An A.R.M. is short for an adjustable rate mortgage. This term has come under fire recently as being a bad thing to have. This is not necessarily the case. There are good arms and bad arms, the trick is being able to identify it so you know what you have and what you are getting.

The key thing to pay attention to on a ARM is the margin, the margin is the fixed portion of your arm, it is the % amount that you are over the index. The index can be many things, home equity lines use the wall street journal prime rate typically. There is also the cost of funds index commonly called the COFI index.

 These loans are not very popular right now but it does not mean they are high rates, there are very few if any companies that are originating them currently. However between 1994 and 2004 if you had one with a reasonable margin then you most likely had the BEST performing mortgage during that time period. With fixed rates so low right now it makes these loans much less popular plus the sub-prime meltdown also made these less appealing to consumers and investors both.