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Adjustable Rate Mortgages (ARM)

Adjustable Rate Mortgages (ARMs) are loans with interest rates that can change over the loan's term. Here are some key points:

  • Initial Fixed Period: The interest rate is fixed for an initial period, typically ranging from 1 month to 10 years.
  • Variable Rate: After the initial period, the rate adjusts based on current market conditions.
  • Initial Rate Advantage: The initial interest rate is often lower than a fixed-rate mortgage, allowing you to afford a more expensive home.
  • Amortization: ARMs are usually amortized over 30 years.

Key Components of ARMs:

  1. Margin and Index:
    • Margin: The fixed percentage added to the index, typically ranging from 1.75% to 3.5%.
    • Index: The financial instrument the ARM loan is tied to, such as:
      • 1-Year Treasury Security
      • LIBOR (London Interbank Offered Rate)
      • Prime Rate
      • 6-Month Certificate of Deposit (CD)
      • 11th District Cost of Funds (COFI)
  2. Rate Adjustment:
    • At the adjustment time, the new rate is calculated by adding the margin to the index and rounding to the nearest 1/8 of one percent.
    • The rate is then fixed for the next adjustment period, which typically occurs annually.
  3. Caps:
    • Initial Cap: Limits how much the rate can increase initially.
    • Periodic Cap: Limits how much the rate can increase during each adjustment period.
    • Lifetime Cap: Limits the total increase over the life of the loan.

Example:

  • Suppose you have a "3/1 ARM" with an initial cap of 2%, a lifetime cap of 6%, and an initial interest rate of 6.25%.
  • Fourth Year Rate: The highest rate you could have in the fourth year would be 8.25%.
  • Lifetime Rate: The highest rate you could have during the life of the loan would be 12.25%.

Pros and Cons:

  • Pros: Lower initial interest rates, potential for rate decreases if market conditions improve.
  • Cons: Uncertainty with future payments, potential for higher rates in the long term.

ARMs can offer savings and flexibility but come with risks, particularly if market interest rates rise. It’s essential to consider your financial situation and future plans when choosing this type of mortgage.