'Adjustable Rate Mortgage (ARM)' is explained in detail and with examples in the Real Estate edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Adjustable Rate Mortgages, also known by their acronym ARM’s, are those mortgages whose interest rates change from time to time. These changes commonly occur based on an index. As a result of changing interest rates, payments will rise and fall along with them.
Adjustable Rate Mortgages involve a number of different elements. These include margins, indexes, discounts, negative amortization, caps on payments and rates, recalculating of your loan, and payment options. When considering an adjustable rate mortgage, you should always understand both the most that your monthly payments might go up, as well as your ability to make these higher payments in the future.
Initial payments and rates are important to understand with these ARM’s. They stay in effect for only certain time frames that run from merely a month to as long as five years or longer. With some of these ARM’s, these initial payments and rates will vary tremendously from those that are in effect later in the life of the loan. Your payments and rates can change significantly even when interest rates remain level. A way to determine how much this will vary on a particular ARM loan is to compare the annual percentage rate and the initial rate. Should this APR prove to be much greater than the initial rate, then likely the payments and rates will similarly turn out to be significantly greater when the loan adjusts.
It is important to understand that the majority of Adjustable Rate Mortgages’ monthly payments and interest rates will vary by the month, the quarter, the year, the three year period, and the five year time frame. The time between these changes in rate is referred to as the adjustment period. Loans that feature one year periods are called one year ARM’s, as an example.
These Adjustable Rate Mortgages’ interest rates are comprised of two portions of index and margin. The index actually follows interest rates themselves. Your payments are impacted by limits on how far the rate can rise or fall. As the index rises, so will your interest rates and payments generally. As the index declines, your monthly payments could similarly fall, assuming that your ARM is one that adjusts down. ARM rates can be based on a number of different indexes, including LIBOR the London Interbank Offered rate, COFI the Cost of Funds Index, and a CMT one year constant maturity Treasury security. Other lenders use their own proprietary model.
Margin proves to be the premium to the rate that a lender itself adds. This is commonly a couple of percentage points that are added directly to the index rate amount. These amounts vary from one lender to the next, and are commonly fixed during the loan term. The fully indexed rate is comprised of index plus margin. When the loan’s initial rate turns out to be lower than the fully indexed rate, this is referred to as a discounted index rate. So an index that sat at five percent and had a three percent margin tacked on would be a fully indexed rate of eight percent.