ARM Mortgage Explained
A mortgage that has an adjustable interest rate based upon an index that is specified in the mortgage contract documents.

An adjustable rate mortgage has an interest rate that is based upon a published index; and will adjust (at an agreed upon period) strictly according to that index regardless of the wishes of the lender, borrower, or any third party. Much like the stock market, exact prediction of the future position of an interest rate is impossible, however, the overall trend of any given index for which an adjustable rate mortgage is based upon can and should be observed prior to any decision or agreement. All adjustable rate mortgages are based upon a rate that can and should be investigated to avoid any future “surprises” regardless of whom the adjustable rate mortgage is offered by. Our Common ARM Indexes page lists many of the typical indexes that Adjustable Rate Mortgages are based upon.

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Are ARM rates tied to the discount interest rate? (The discount interest rate is set by the Federal Reserve and is always discussed by news stations when it is adjusted. See our Interest Rates section for a more in-depth explanation) Yes, somewhat. All American interest indexes are indirectly tied to the discount interest rate; however, how they adjust in relationship to the discount rate is different. Some may change instantaneously others may lag behind due to the particular characteristics for which the index is based upon. The main theme to recognize is the trend of the discount interest rate; If the trend is heading up (or down) all interest rates will eventually follow – there may be a short period where it appears that rates are heading in different directions (once again, which is based upon the factors that influence the particular interest rate) but the trend direction of the discount interest rate is the direction where all interest indexes are eventually headed.

Principal features of ARMs:

  • Initial Interest Rate – Introductory rate for the Adjustable Rate Mortgage.
  • The Adjustment Period – The amount of time between payment recalculations. ARMs typically have two adjustment periods: the initial interest rate period, and the adjustment period after the initial interest rate period.
  • The Index Rate – The index which a particular Adjustable Rate Mortgage is based upon. See our Common ARM Indexes page for more details
  • The Margin – An extra amount of interest the lender and/or broker tacks onto the interest rate to generate their profit. Some lenders base this amount of interest they charge you on their interpretation of your credit report
  • Interest Rate Caps – An interest cap dictates the maximum amount of interest that can be charged over the period or lifetime of the Adjustable Rate Mortgage.
  • Payment Caps – A payment cap establishes the maximum dollar amount (or dollar amount change) allowed over the period or lifetime of the ARM. A payment cap can lead to negative amortization if the interest rate on the ARM increases monetarily beyond the cap amount. This unpaid “surplus” is added to the principal balance causing what is called “negative amortization”.
  • Initial Discounts – often called a “teaser” rate – Typically a very low introductory interest rate offered at the beginning of an ARM as an enticement.
  • Negative Amortization – Negative amortization means the mortgage balance is increasing. Many lenders will recast (recalculate) and increase the remaining mortgage payments due if a loan balance increases beyond a set limit; typically 110% to 125% of the original loan balance. Please see “Payment Caps” above for an example how a mortgage balance can increase.
  • Conversion – A stipulation in the loan documents that would allow the buyer to convert the ARM to a fixed-rate mortgage at a future date. Fees are typically associated with this feature.
  • PrepaymentOccasionally an ARM can contain a clause that would require the buyer to pay special fees or penalties if it is paid off early. Some lenders will renegotiate prepayment penalties.
  • Carryover – A carryover clause in combination with a payment or interest rate cap can cause your mortgage payment to go up at a periodic change, even if the interest rate goes down. This clause allows any interest or payment increases that were not applied due to a cap, to be carried over to the next adjustment period.

Adjustable Rate Mortgages are available in many initial payment period and adjustment interval flavors: 3/1, 5/1, 7/1, 10/1, 3/3, etc. The following sketch shows what these number ratios mean.

Adjustable Rate Mortgage (ARM) sketch

Many Adjustable Rate Mortgages offer caps to control the maximum amount of interest that a loan can adjust in any given period as well as a lifetime cap that dictates the maximum amount of interest an Adjustable Rate Mortgage can accrue over the lifetime of the loan. Some ARM’s specify a maximum dollar amount that can be required for a monthly payment or a maximum dollar amount that can be added to a payment regardless of the amount dictated by an interest rate adjustment. Please be aware that an interest cap and a payment cap are two very different animals. As stated above under our “Principal features of ARMs” section, an interest cap dictates the maximum amount of interest that can be charged over the period or lifetime of the Adjustable Rate Mortgage. Again as stated above under our “Principal features of ARMs” section, a payment cap establishes the maximum dollar amount (or dollar amount change) allowed over the period or lifetime of the ARM. The later (payment cap) can lead to negative amortization if the interest rate on the ARM increases monetarily beyond the cap amount. This unpaid “surplus” is added to the principal balance causing what is called “negative amortization”.

Advantages:

  • Low initial monthly mortgage payments.

Disadvantages:

  • Adjustable Rate Mortgages can adjust sharply upward after the initial payment period if interest rates move significantly upward.
  • ARM’s can be confusing.

Adjustable Rate Mortgage Types:

  • Hybrid ARM: – The 7/1 ARM highlighted in the sketch above is a hybrid ARM. Hybrids have an initial fixed period lasting any number of months or years followed by an adjustable period that typically adjusts annually.
  • Interest Only ARM: – An Interest-Only ARM is a mortgage where a monthly mortgage payment will only cover the interest portion of the loan. This interest-only period of the loan will typically have a term of three, five, seven, or ten years after which the monthly mortgage payments will increase to begin including a portion of the principal of the loan. An Interest-Only mortgage is often selected due to its attractive initial low monthly payments. Interest-Only Mortgage options are available for both Fixed Rate Mortgages and Adjustable Rate Mortgages.
  • Payment Option ARM: – The option ARM is an adjustable rate mortgage that allows you to choose between several payment options each month. Typically an option ARM statement will offer several amounts for you to choose between, each of which is a different sort of payment. Some typical options are:
  • Traditional payment of principal and interest
  • Interest only
  • Minimum payment – this payment does not cover the interest accrued for the month resulting in negative amortization (discussed above under “Principal features of ARMs”)

Types of Mortgages that ARMs can be used toward:

  • Bi-weekly mortgage or bi-monthly mortgage – As the names imply, these mortgage types have two payments per month. What’s the difference you ask? Plenty, actually. A bi-monthly mortgage is essentially the same as a typical monthly mortgage except that payments are made twice a month – monthly mortgage payment split in half and paid every two weeks. A bi-weekly mortgage deducts the amount reduced from the principal with every mortgage payment so that the total calculated interest is reduced and therefore reduces the term of the loan. This may seem like peanuts at face value but actually can be quite substantial as a typical 30-year fixed rate mortgage that is set up for bi-weekly payments will be paid off in a little under 24 years. Please see our Bi-weekly Mortgage Rate section to view some Bi-weekly Mortgage Rates.
  • Jumbo or non-conforming mortgage – A Jumbo or non-conforming mortgage is a loan in excess of $417,000 (In 2008, The Housing and Economic Recovery Act changed the conforming loan limit in “high-cost” areas to $729,750). This figure is currently the eligibility limit for purchase by Fannie Mae or Freddie Mac. Nearly all Jumbo or non-conforming mortgages have a higher interest rate then their counterpart; the conforming mortgage.
  • Balloon mortgage – A balloon mortgage is a mortgage that will have payments that are calculated much the same way as a 15-year fixed rate mortgage, 20-year fixed rate mortgage, 30-year fixed rate mortgage, or 40-year fixed rate mortgage dependant on which option you choose. After a set period of time, typically 5-years, 7-years, or 10-years, the total amount loaned minus the mortgage payments made will be due in a lump sum. Rates for these types of loans are usually lower than both Fixed Rate Mortgage interest rates and Adjustable Rate Mortgage interest rates.
  • Construction Mortgage – A Construction Mortgage is often found as a two-part loan. The first part of the Construction Mortgage will typically be an interest only loan that will charge the loan purchaser an interest only payment based on the amount of the loan that has been spent on the construction project – these loans are usually dispersed on a borrow as you need basis up to a fixed amount. The construction portion of the loan will generally have a term limit of between six and twelve months. The second part of the Construction Mortgage begins upon completion of the construction project at which time the loan purchaser can select the type of mortgage to “roll” the Construction loan into. This can be a Fixed Rate Mortgage, Adjustable Rate Mortgage, Jumbo Mortgage, Balloon Mortgage, etc. A Construction Mortgage will usually have two separate closing periods; one at the construction commencement, the other at construction completion both incurring separate closing fees. Recently some mortgage providers have begun to offer “single closing” construction loans.
  • Second Mortgage – A second Mortgage is often a Home Equity Loan or Home Equity Line of Credit (HELOC) both of which are discussed in their own sections. The Second Mortgage can be a Fixed Rate Mortgage, an Adjustable Rate Mortgage, or a Home Equity Line of Credit all with their differing interest rate characteristics. In the event of default on a home with both a primary and Second Mortgage, upon fund recovery the primary mortgage is paid first leaving the Second Mortgage with whatever (if anything) is left. As a result, a Second Mortgage will often have a higher interest rate than a primary mortgage (with the exception of the adjustable rate second which will often have lower interest rates much like an Adjustable Rate Mortgage). See our Second Mortgage Explained section to explore Second Mortgages in greater detail. Including links to some handy calculators that will help explain your Second Mortgage options

Before You Sign – What to watch out for:

  • Use this Mortgage Shopping Worksheet, provided by the United States Federal Reserve Board, to compare different ARM’s from the same lender, ARM’s from different lenders, or to compare a Fixed Rate Mortgage to an Adjustable Rate Mortgage. This form will give you a detailed view of the cost of differing types of loans both now, and in the future.
  • A quick question to weed out the bad guys: When a lender or broker quotes a suspiciously low initial interest rate and payment on a loan, ask them for the annual percentage rate (APR). An APR that is considerably higher than the quoted initial interest rate will generally mean that your loan payments will increase significantly at the adjustment period, even if interest rates remain the same. This low initial interest rate is called a “teaser rate”.
  • Ask your lender, Mortgage broker, or Title officer for a copy of your Balance Sheet, Closing Statement, or Settlement Cost Sheet. (This document is called many different things by different institutions; use any of these terms and your lender, broker, or title officer should understand what you’re looking for.) By law, a borrower is entitled to review the settlement cost sheet one business day before closing on the loan – You absolutely must exercise this right and ask questions if you find something you don’t understand! Please follow the link above to find out what should be included in this document and why it matters to you.
  • Lenders must provide you with written information regarding the ARM mortgages that you are interested in. This information must include:
  • Loan terms & conditions
  • The name of the Interest Rate Index that the ARM is based upon
  • The margin added to the index by the lender or broker – profit
  • How the interest rate is calculated
  • The period of the interest rate change
  • Limits on the changes
  • An example of how high your monthly payments can become
  • An explanation of how negative amortization may effect you loan
  • Not all adjustable rate mortgages are set up to adjust downward – ask your broker or lender about this stipulation, especially if you’re shopping for a mortgage during a high interest rate period
  • Check introductory rates and periods. Ask your lender to map the loan out precisely in a fashion you understand.
  • Check for and ask about prepayment penalties
  • Verify account maintenance fees and/or servicing fees before signing.
  • Ask your lender, broker, or Title officer for an accounting estimate of all up-front fees you will be charged. These charges may come from the lender, title company, other third party, etc.
  • Interest Only Mortgage Options – Understand when principal will begin to be added to your monthly payments.
  • Balloon Mortgage Options – Understand exactly when the balloon payment will be due.
  • Construction Mortgage – to avoid an unexpected set of second closing costs, Verify whether your Construction Mortgage has one or two closings (see Construction Mortgage above).
  • A couple minor additional costs not included on the preliminary closing statement due to last minute unforeseen charges and exact interest calculations should be expected. These costs should be very small and typically not amount to more than a couple hundred dollars.

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We are not mortgage professionals nor do we claim to be. All information on this site is provided for informational purposes only. Individuals should always consult a real estate attorney prior to making any real estate commitments which they may not understand.