How does an ARM work?

OVERVIEW:  Adjustable Rate Mortgages (ARMs) are loans whose interest rate can vary during the loan's term. These loans usually have a fixed interest rate for an initial period of time and then can adjust based on current market conditions. Normally, the initial rate on an ARM is lower than on a fixed rate.  Adjustable rate mortgages are usually amortized over a period of 30 years with the initial rate usually being fixed for anywhere from 3 to 10 years.   For example, if you have a 5/1 ARM, your initial fixed rate period would be 60 months; a 7/1 ARM initial period would be 84 months; and so on.  After your intital fixed period, your mortgage moves into the adjustable rate period (and stays there for the remaining term of the loan).

WHAT MAKES UP MY INTEREST RATE?:  All ARM loans have a "margin" plus an "index" and the two added together make up your interest rate.  It's important you know the margin and index for your loan.  Margins on loans usually range from 2.25% to 3.00%.  The index is the financial instrument that the ARM loan is tied to such as: 1-Year U.S. Treasury Rate, The 1-Year LIBOR Rate (London Interbank Offered Rate), and the current Prime Interest Rate.

HOW OFTEN DOES MY INTEREST RATE CHANGE?:  As stated above, ARM mortgages start with an initial "fixed" interest rate period and interest rate.  At the expiration of this fixed period, the interest rate will start to adjust.  To calculate the interest rate moving forward, the margin will be added to the index and typically rounded to the nearest 1/8 of one percent to arrive at the new interest rate. That rate will then be fixed until the next adjustment period (normally every 12 months).  And, for the remaining term of your loan, the interest rate will adjust annually.

DOES MY PAYMENT CHANGE WHEN MY INTEREST RATE CHANGES?  Yes.  This is the part of ARM loans mechanics that gets missed the most.  The payment moves up to cover the additional monthly interest on the loan.  And, based on the 2017 increases in the the three indices that price ARM loans, your mortgage rate will likely increase.  If your interest rate increases 1.0% and you have a $300,000 balance, your monthly payment would increase approximately $249.99 per month.  A jumbo mortgage balance of $750,000 would have a payment increase of $624.97.  Any subsequent annual rate increases will move the monthly payment up higher.

IS THERE A MAXIMUM INTEREST RATE ON MY LOAN?   Yes, almost all ARM mortgages have a "lifetime cap". Suppose you had a 5/1 ARM with an initial cap of 2%, a lifetime cap of 6%, and initial interest rate of 3.50%. The highest rate you could have in the fifth year would be 5.50% (initial cap) and the highest rate you could have during the life of the loan would be 9.50% (lifetime cap).