The adjustable rate mortgage is a loan with an interest rate that adjusts at set intervals. The frequency at which the adjustable rate mortgage adjusts, depends on the borrowers choice during financing.
There are many different adjustable rate mortgage products available with 3/1, 5/1, 7/1 being the most common. The first number in loan program is for how many years the interest rate remains fixed.
The second number is for how often the rate will adjust after the fixed period ends.
Limitations known as caps are commonly used to limit the risk borrowers take when choosing adjustable rate mortgages.
Caps such as 5/2/6 on a typical 3/1 arm apply as follows:
- The “5” shows the interest rate can adjust up or down a maximum of 5% after the initial 3 year fixed rate period ends.
- The “2” shows the interest rate can move up or down a maximum of 2% on subsequent annual adjustments.
- The “6” shows the interest rate cannot move more than 6% above or below the initial fixed rate over the life of the loan.
When shopping interest rates for an adjustable rate mortgage you’ll have a choice between a fully amortized or interest only adjustable rate mortgage.
Fully amortized means you must pay principal and interest payments, while interest only means you have the choice to make interest payments or you can choose to make principal and interest payments.
- Initial – The “5” shows the interest rate can adjust up or down a maximum of 5% after the initial 3 year fixed rate period ends.
- Periodic – The “2” shows the interest rate can move up or down a maximum of 2% on subsequent annual adjustments.
- Lifetime – The “6” shows the interest rate cannot move more than 6% above or below the initial fixed rate.
Looking through loan documents should shed light on which index (LIBOR, COFI, MTA, T-BILL, CMT, etc.) your loan is tied to and what margin you agreed to, knowingly or not. Check the local paper for your index and add the margin, that’s your current interest rate.
Index = New interest rate
If the loan officer can saddle you with a large margin, then you’re going to have a higher interest rate after the first adjustment. Not to mention he’ll be pulling a larger profit on the loan.
Adjustable rate mortgages are great products when used properly. When shopping for one make sure it’s going to fit your particular situation as all adjustable rate mortgages will carry more risk than a fixed rate product.