Standard Adjustable Rate Mortgage (ARM)

We're calling this the Standard ARM, but we should note that there is something on the order of 100 different ARM products on the market. The variations and nuances are nearly endless. Here we just want to review the basics, your lender will provide the real details.

Adjustable mortgages usually have a low, fixed introductory interest rate relative to the prevailing 30-year rates. That low rate is to entice you to accept the risk that rates and monthly payments may be higher after the fixed period ends.

Further Details:

To start with, your payments are initially amortized as if they were going to last at the introductory rate for 30 years. And, as with a conventional mortgage, a portion of each payment is going toward interest, a portion toward principle. But the low rate ends after a specified period (typically 1, 3, 5, 7, or 10 years). And then the interest rate and monthly payments are adjusted up or down at periodic intervals – such as every 3, 6, or 12 months – based on a recognized index used in the general financial markets.

Examples of indices are LIBOR (London Inter-Bank Offered Rate), COFI (Federal Reserves 11th District – Cost of Funds Index), CODI (Certificate of Deposit Index) and the MTA (Monthly Treasury Average). Check with your banker for specifics.

If the current 30-year rate is 6%, for example, the introductory rate might be in the 5% to 5½ % range. The rate you get will depend on the fixed period. The shorter the term, the lower the initial rate. If you choose a 3-year ARM, your rate might be fixed at 5% for 3 years. If you choose a 10-year term, your rate may be
5¾ % for that period.

Regardless of the fixed term, when it’s finally up, the interest rate floats up or down with the fluctuations of the index relevant to your loan. The good news is there are periodic adjustment caps and lifetime caps. These help protect you from large changes in payments should interest rates change dramatically.

Your loan agreement, for example, may say that the mortgage rate can’t go up more than 2% in any adjustment period. If the initial rate was 5%, the first adjustment could not be greater than 2%, so your effective rate could go no higher than 7% during that period.

And the lifetime cap limits the total amount the interest rate can rise over the life of the loan. Perhaps your loan provides for a lifetime cap of 5%. If the initial rate was 5%, the rate can never go above 10%.

ARMs offer advantages that may be appealing to some buyers. During the introductory period, ownership costs are relatively low. Some of you may choose to invest the savings (over a conventional loan) elsewhere.

Or, you may prefer to use an ARM to stretch up and purchase an apartment you could not afford if you went the conventional route.

We must emphasize that the risk of an ARM is, of course, that your monthly payments may go up significantly when the fixed period ends. As we’ve indicated, there are limits in your loan contract as to how much payments can jump. Your lender will explain the possible scenarios. And, if it makes sense, as you approach the end of your fixed term, you can always refinance your loan, perhaps with another ARM.

ARMs can be a great option if you are reasonably confident you will not stay in your apartment longer than the fixed period, or that your income is likely to rise significantly in the near future. Discuss any concerns with your banker before signing up. If your comfortable with the risks, however, this can be a great way to buy what you really need in today’s market.

Note: lenders may give you the option of paying "points" to get a lower interest rate. A point is 1% of the loan value. Your lender will explain the point/no point options.

Caution: some ARMs have features that lead to "negative amortization". Negative amortization results when unpaid interest is added to the underlying loan balance. This can occur when the ARM agreement requires a change in the loan rate every month or every 3 months, based on movement of the reference index. Yet your monthly payment adjusts on a longer cycle, say every 6 or 12 months. It’s possible for your payment over a period of months to be insufficient to cover the actual interest owed. The terms of your loan may allow the lender to add any unpaid interest to the principle balance. The loan balance is growing, in other words, not shrinking. Make sure to ask your lender if the ARM she is suggesting has features that potentially could lead to owing more than you originally borrowed. If you're knowledgeable and comfortable, these features are not necessarily bad – you just need to be aware of them.

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