Adjustable-Rate Mortgage (ARM) is a type of mortgage loan where the interest rate is not fixed for the entire loan term. Instead, the interest rate can adjust or change periodically based on a specific financial index, such as the London Interbank Offered Rate (LIBOR) or the US Prime Rate.
How an Adjustable-Rate Mortgage works
- Initial fixed-rate period: At the beginning of the loan term, there is usually an initial fixed-rate period. It can range from a few months to several years. During this period, the interest rate remains fixed and does not change. This initial period is often denoted as “3/1 ARM” or “5/1 ARM,” where the first number represents the number of years the rate is fixed, and the second number represents how frequently the rate can adjust thereafter.
- Adjustment period: After the initial fixed-rate period, the interest rate on an ARM will start to adjust periodically. The adjustment period is the length of time between rate adjustments. It is commonly set to one year (annually), but there are also ARMs with adjustment periods of three years, five years, or even longer.
- Index and margin: The interest rate adjustments are based on an index, such as LIBOR or the US Treasury rate. The lender adds a margin, which is a predetermined percentage, to the index rate to determine the new interest rate. The margin remains constant throughout the loan term.
- Rate adjustment: When the adjustment period ends, the lender recalculates the interest rate. It is based on the current value of the index. If the index rate has changed, the interest rate on the ARM will also change. This adjustment can result in a higher or lower monthly payment, depending on the direction of the index rate movement.
- Cap limits: To provide some level of protection to borrowers, ARMs typically have caps that limit how much the interest rate can increase or decrease during each adjustment period or over the life of the loan. These caps are defined in the loan agreement and can vary depending on the specific terms of the mortgage.
Benefits and Risks of an Adjustable-Rate Mortgage
It’s important to carefully consider the potential risks and benefits of an Adjustable-Rate Mortgage. The advantage of an ARM is that the initial interest rate is often lower than that of a fixed-rate mortgage, which can make it more affordable in the short term. However, the uncertainty of future interest rate changes means that monthly payments can increase over time. This potentially leads to higher costs in the long run. Borrowers should assess their financial situation and future plans to determine if an ARM aligns with their needs and risk tolerance.
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