How does an arm mortgage work
Editors note: Rates quoted in this post are from 2007 – when it was originally published. For a current rate quote for your home located in Washington, click here.
Adjustable Rate Mortgages, also referred to as ARMs, come in many shapes and sizes. This post will be focusing on fixed period ARMs, such as the 3/1, 5/1, 7/1, 10/1…etc. that feature a fixed rate period before adjusting.
We’ll pick on the 5/1 ARM to make things easy. The first digit (5 /1) is how long the initial rate period is fixed for. With the 5/1 ARM, that would be 5 years or 60 payments. The second digit (5/1 ) is how often the ARM will adjust after the fixed period (at the 61st payment with a 5/1 ARM). Your rate will continue to adjust once a year on the anniversary of the first adjustment date.
You may also see 5/6 ARMs, that means the payments will adjust every 6 months instead of once a year.
You also need to know what your CAPS are. The CAPS are in place to restrict how high or low your ARM can adjust. And just like ARMs, they can vary too. Common CAPS are 5/2/5 or 2/2/6 for the 5/1 ARM.
The first digit with the CAPS (2 /2/6), is how much the interest rate can adjust at the first adjustment point. So, if you have a 5/1 ARM, with 2/2/6 CAPs, your rate may adjust up or down no more than 2% at the first adjustment date. If you have 5 /2/5 CAPS, the rate could adjust no more than 5% up or down.
The second digit of the CAPS (2/2 /6), is how much the rate may adjust up or down after the first adjustment every adjustment point thereafter (once a year, if you have a 5/1 ARM; every 6 months if you have a 5/6 ARM).
The last digit of the CAPS (2/2/6 ), is the highest the the rate could ever adjust to; the ceiling.
When your fixed period is over, your rate will adjust based on what your mortgage balance is at the adjustment time (60 months, per this example). The formula for this is preset by the margin to the index . The index may be based on several options.
The margin may vary as well such as 2.25% – 2.875% for prime mortgages (subprime mortgages and option ARMs may have larger margins).
Heres an example of a 5/1 LIBOR ARM with Caps of 2/2/5 and a margin of 2.875 based on a $200,000 loan amount with a start rate of 5.625% (for purposes of an example only – this is not a rate quote. APR 8.486 assumes worse case scenario). If you would like a current rate quote for an ARM for property in Washington state, click here .
Principal and interest payment for 5 years: $1,151.31
Balance at 60 months (assuming no additional payments towards principal): $185,227. Maximum Interest Rate at First Adjustment (61 months): 7.625%
Maximum Principal and Interest Payment at first adjustment for one year (months 61 – 73): $1,383.89.
Maximum Lifetime Interest Rate: 10.625%
Maximum Principle and Interest Payment assuming it takes place at the earliest point possible worse case scenario at all adjustment periods at month 85 = $1599.13.
Note: With the 2% annual adjustment cap, worse case scenario, it would take 8 years to max out at 10.625%. Assuming worse case with the 2% annual cap and 5% lifetime cap; 1st adjustment @ month 61 = 7.625; 2nd adjustment @ month 73 = 9.625%; 3rd adjustment month@ 85 = 10.625%.
Your rate and payment can adjust downwards as well depending on the performance of the index your ARM is based on. Interest only ARMs are a different animal. The caps and margins still work the same. The big difference is how long the interest only period is (when the amortization of the mortgage begins)…I will follow up on this on another post.
With ARMS, it’s important to find out from your Mortgage Planner what your CAPs are and what the margin is. This should be disclosed on your lock confirmation. However, this may be something you wish to find out from your Mortgage Planner well in advance, especially if your comparing ARM rates, you should have the entire picture to compare apples to apples (or should I say, arms to arms).
ARMs can be great financial tool if someone considering not retaining the property or the mortgage for a long term and if the rate is advantageous over a product such as the 30 year fixed rate.Source: mortgageporter.com