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Mortgage Rates
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Adjustable-rate mortgages
Adjustable-rate
mortgages, also called ARMs, offer an interest rate and monthly payment
that fluctuate according to market interest rates.
Most ARMs start out with a lower initial interest rate than fixed-rate loans. During this initial period, the borrower's rate remains the same. After the initial period expires, the interest will reset at preset amounts of time.
The initial interest period can be anywhere from a month to 10 years. One-year ARMs are fairly popular. They begin adjusting in interest after one year. But in the last few years, five-year ARMs have increased in popularity. They have a fixed initial interest rate for five years after which they adjust annually. The five year and other ARMs with lengthy initial interest periods are known as hybrids. You will often see hybrids written as 3/1, 5/1 or 10/1. The first number is the initial period; the second number is how often the interest rate adjusts. So for 3/1, the interest rate is fixed for three years and then adjusts once a year for the remainder of the mortgage.
After the fixed-rate period, the loan will adjust at the same rate as an index that is spelled out in the closing paperwork. The lender will look at the index, add a margin to the figure and adjust the borrower's interest rate accordingly. This happens every time an adjustment date rolls around.
Most rates for adjustable mortgages are tied to one of three major indexes:
The weekly constant maturity yield on the one-year Treasury Bill;
The 11th District Cost of Funds Index (COFI); or,
The London Interbank Offered Rate (LIBOR).
With an ARM, when the interest rate increases, the monthly payment increases. When the interest rate decreases, the monthly interest rate follows.
Most ARMs come with caps to keep the borrower's interest rate from skyrocketing. These are usually annual caps that prohibit how much an interest rate can increase during a year.
Look for three different types of caps when looking at mortgages with adjustable rates:
Periodic rate cap: This cap limits how many percentage points the rate can change at any one time. These are usually annual caps that prevent the rate from rising more than a certain amount in one year.
Lifetime cap: This cap limits by how much the rate can rise over the entire life of the loan.
Payment cap: This cap is offered on some ARMs. It limits how much the monthly payment can rise over the life of the loan in dollars, rather than the change in interest rate.
In the last few years, new forms of ARMs have emerged. One of these is the interest-only mortgage. These were originally offered to "affluent customers," but are increasingly popular with many different levels of borrowers. The borrower is only required to pay the interest that accumulates on the loan for a specific period of time, for example 10 years. After the first 10 years are up, the rate begins adjusting on an annual basis. The borrower will also be required to start paying back the balance on the mortgage as well.
Interest-only mortgages allow borrowers the flexibility in the size of monthly payments. They are often a wise fit for those who expect their income to increase in the future. You should be aware of the increase of the monthly payment when the principal is due and when the interest starts amortizing.
Some ARMs will allow you to convert to a fixed-rate mortgage for a fee, called a conversion. Other ARMs allow borrowers to make minimum payments on their mortgage for a certain period of time. The availability of so many options makes ARMs difficult to understand.
Make sure that you ask your lender if the ARM is convertible
to a fixed-rate mortgage. You should also ask if the mortgage is
assumable. Make sure that you understand all the terms and the potential
interest rate you may be facing with an adjustable rate mortgage.