Understanding Adjustable-Rate Mortgages (ARMs)

How Adjustable-Rate Mortgages (ARMs) Work

An Adjustable-Rate Mortgage (ARM) is a type of home loan where the interest rate is not fixed for the entire loan term. Instead, the interest rate can change periodically based on an underlying index, such as the prime rate or LIBOR (though LIBOR is being phased out). This means your monthly mortgage payments can go up or down over time.

ARMs typically start with an initial fixed-rate period, during which the interest rate remains constant. This period can range from 3 to 10 years (e.g., 5/1 ARM means a 5-year fixed period, then adjusts annually). After the fixed period, the rate adjusts at predetermined intervals, usually once a year.

The Role of Interest Rate Caps

To protect borrowers from extreme rate increases, ARMs include interest rate caps. These caps limit how much the interest rate can change:

• Initial Adjustment Cap: Limits how much the rate can increase or decrease at the first adjustment after the fixed-rate period.
• Periodic Adjustment Cap: Limits how much the rate can change during any subsequent adjustment period (e.g., annually).
• Lifetime Cap: Sets the maximum interest rate that can be charged over the entire life of the loan. This is a crucial safeguard.

Example Calculation: ARM Adjustment

Let's say you have a 5/1 ARM with an initial rate of 3.0%. After 5 years, the fixed period ends. The index rate has increased, and your new rate is calculated based on the index plus a margin (e.g., Index + 2.5%).

If the index is now 2.0%, your new fully indexed rate would be 2.0% + 2.5% = 4.5%. If your periodic cap is 1.0%, and your previous rate was 3.0%, the new rate cannot exceed 3.0% + 1.0% = 4.0%. In this scenario, even though the fully indexed rate is 4.5%, your rate would be capped at 4.0% for that adjustment period.