Adjustable Rate Mortgage Program

An Adjustable Rate Mortgage (ARM) can be a good alternative to the fixed-rate mortgage program. For those who are seeking the lowest rate and payment combination, Adjustable Rate Mortgages are the place to start looking. There are a many reasons why you might want to consider an Adjustable Rate Mortgage. For example, here are a couple scenarios in which an ARM would make sense:

  • Selling Your House: If you are planning on selling your house in the next few years, save money by taking advantage of the lower interest rates during an Adjustable Rate Mortgages initial fixed rate period.
  • Upcoming Expenses: If you are planning on pulling cash-out of your property in the next couple years (e.g., College Tuition, Remodel). When you go to pull cash-out of your property, you will be getting a new loan at the then current market rates. This means that you will have lost money if you were to go with or keep a higher interest rate loan while you are waiting to pull the cash out of your property.
  • Short Term Borrowing: Temporarily using the equity in your property may be a good alternative to liquidating assets or using capital reserve for purchases or investments
  • Cash Flow Management: If you are looking to purchase more home than you can currently comfortably afford or need a reprieve from a larger mortgage payment, then an ARM may be the solution. This is usually the case when you are expecting a promotion, an increase in business, or some other increase in monthly income.

How It Works:

Initial Fixed Rate Period: Most ARM program advertisements will say: “3/1 ARM”, “5/1 ARM”, or “7/1 ARM”. The first number is the initial fixed rate period of the ARM. For a 3/1 ARM, the initial fixed rate period would be for 3 years. In other words, the initial interest rate on a 3/1 mortgage will be fixed for a period of 3 years. During this initial fixed rate period, an Adjustable Rate Mortgage is no different than a Fixed Rate Mortgage. The interest rate cannot change during this time. The second number, in this case “1”, is the frequency at which the interest rate will adjust after the initial fixed rate period. On a 3/1 ARM, after the initial fixed rate period has expired, the interest rate will adjust every one (1) year.

Adjustable Rate Period: After the initial fixed rate period has expired, the interest rate will adjust. After the initial fixed rate period has expired, we call the rate ‘fully adjustable.’ With a few minor exceptions, your new adjusted rate will have nothing to do with the initial fixed rate. To determine what the new interest rate will be, we need to discuss a few other aspects in common with every adjustable rate mortgage. But first, let’s take a look at the equation:

Margin + Index = Interest Rate

The Margin: The margin is a constant. It is set at loan funding and will not change throughout the life of the loan. Typically, the margin is 2.25%.

The Index: The index is the variable aspect of an adjustable rate mortgage. The most common index in an ARM is the 1 Year LIBOR (London Interbank Offered Rate.) As of the time of this writing, the current 1 Year LIBOR Rate is 0.84%.

If you had a 3/1 ARM that was adjusting today, the interest rate would be the margin, 2.25%, plus the index, 0.84%, to give you a new adjusted rate of 3.125%. For those of you following along, the interest rate is 3.125%, and not 3.09%, because the interest rate is typically rounded to the nearest eighth of a percent.

Interest Rate Caps: Interest rates can increase or decrease after the initial fixed rate period, but there limits to how high or how low an interest rate can adjust.

Initial Adjustment Cap: The Initial Adjustment Cap is only applicable for the first interest rate adjustment after the initial fixed rate period has expired. For example, if the initial fixed rate was 2.5%, and the Initial Adjustment Cap is 2%, the highest the interest rate could increase during the first adjustment period would be 4.5%.

Periodic Adjustment Cap: The Periodic Adjustment Cap is the cap used for every adjustment period after the initial adjustment. If your interest rate was 4.5% after the initial adjustment and if your Periodic Adjustment Cap was set to 1%, the highest your interest rate could adjust to during the next adjustment period would be 5.5%.

Life Cap: This number plus the initial interest rate is the highest the interest rate can ever get. If the Life Cap is 5%, and the initial rate is 2.5%, the highest the interest rate can ever get to is 7.5%. In many cases, the Life Cap and the Initial Adjustment Cap are the same.

The Floor: This is lowest the interest rate could ever adjust (i.e. The Floor). It is typically set to either the initial interest rate or the margin.

Features & Benefits:

  • In most cases, ARMs have lower initial interest rates that than fixed-rate mortgages.
  • Interest rates and monthly payments will be fixed for an initial period of 3, 5, 7, or 10 years.
  • Interest rates have caps that limit how high the interest rate can go.
  • Adjustable Rate Mortgages can also be combined with an Interest Only option for maximum monthly payment savings.

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