One option for home buyers or homeowners who want to refinance is an adjustable-rate mortgage or “ARM.” Unlike with fixed-rate mortgages, ARM interest rates can change over the loan term, at specific time periods based on the loan agreement. Borrowers choose ARMs for many reasons, for example, when they can either (a) get an introductory rate better than a current fixed rate or (b) they expect future rates to decline and they don’t want to go through the refinance process. Here are the basics for ARMs.
The interest rate includes an “index” and a “margin.” The index is the benchmark for calculating the ARM interest rate and future adjustments to the rate. For example, some ARMs use the SOFR (Secured Overnight Financing Rate) as the index. Other often-used indices are T-Bill, CMT and COFI. The rate for an ARM changes with its specified index as the index goes up and down. The margin is a percentage added to the index to determine the interest rate for the specific ARM loan. If the index rate is 5.5% and the margin is 2.5%, then the interest rate for the ARM is 8%.
The next key component is the adjustment period. ARMs have an introductory period and a recurring periodic adjustment period. For example, a 7 / 1 ARM has an introductory period where the interest rate stays fixed for the first seven years. After the introductory period, the rate can adjust every year. A 3 / 6 ARM has a 3-year introductory period and the interest rate adjusts every 6 months thereafter. Remember, interest rate pricing is all about risk. The longer the time period an interest rate is fixed, the greater the risk to the lender so the higher the interest rate. Borrowers can expect ARMs with a 7-year intro period will have a higher introductory interest rate than for a 3-year ARM.
The next key component of an ARM is the “cap.” An ARM typically has 3 caps:
- Initial cap – limits how much the interest rate can change on the first adjustment.
- Periodic cap – limits how much the interest rate can change on each subsequent adjustment.
- Lifetime cap – limits how much the interest rate can change over the lifetime of the loan.
For example, if an ARM has 3 / 1 / 5 specified caps, the following will be true. When the introductory period ends, the initial interest rate adjustment can be a maximum of 3%, even if the index has changed by 4%. All subsequent adjustments are limited to 1%. And the maximum change to the interest rate over the lifetime of the loan – the initial adjustment plus all subsequent adjustments – is limited to 5%. This limits the borrower’s risk as market interest rates change over time.
Considering a home purchase in Georgia and wondering if an ARM is right for you? Give me a call to discuss loan options and we can review the pros and cons of ARMs vs fixed-rate mortgages. I’ll help you navigate all the details and win you a competitive interest rate on your new mortgage.
