An ARM (Adjustable Rate Mortgage) is a particular type of mortgage scheme in which the interest rates are flexible or adjustable or variable in nature. It means that the interest rates change based on any particular index (example LIBOR) and it is more or less adjusted in a way to always benefit the lender irrespective of market changes.
An ARM is typically a common solution for all the financial institutions and banks that cannot actually afford the risk of fixed loans. An adjustable rate mortgage is a more risky mortgage or loan as the Interest rate can increase in future and the upward movement is very hard to predict.
Basic Characteristics of ARM:
Initial rate and payment: The initial rate and the payment amount on an ARM remain unchanged only for some initial period of time which can range between 3 months to as long as 5 years. For some of the ARMs, the initial rate and the payment are significantly different from the rates and payments that are to happen later in the loan term.
The adjustment period: With most of the ARMs, the interest rate and the monthly payment change every month, quarter or after every year. The period between these rate changes is termed as adjustment period.
The Index and The Margin: The interest rate component on an ARM is typically made up of 2 parts,
the index and the margin. The index is a standard measure of the interest rates generally while margin is said to be few extra percentage (%) points to the index-rate that the lender adds to set the interest rate on an ARM. There are basically 5 types of indexes that are used to calculate the interest rates on the ARM’s which are
LIBOR (The London Interbank Offered Rate)
CMT (Constant Maturity Treasury)
COFI (The 11th District Cost of Funds Index)
MTA (The 12-month Treasury Average Index)
The National Average Contract Mortgage Rate
Interest-rate caps: An interest-rate cap is defined as the limit for the maximum interest rate. It can be of two types, one is Periodic adjustment cap which limits the amount the interest-rate can go up/down from one adjustment period to next adjustment period and other is Lifetime cap which restricts the interest-rate increase over the total life of the loan. By law, practically all the ARMs are supposed to have a lifetime cap.
Payment Caps: Many ARMs limit or cap the amount that the monthly payments can increase at the time of each of the adjustments which could lead to negative amortization later on.
Types of Adjustable Rate Mortgages:
Interest-only ARMs: An interest-only ARM payment plan allows the individual to pay only the required interest amount for a specified number time. This scheme allows lower monthly payments for a certain period of time after which periodic payments increases significantly even though the interest rates remain same due to inclusion of both principal and interest payments.
Hybrid ARMs: These are typically a mix of mortgages with fixed rate period and also an adjustable-rate period. In this case the rate of interest stays constant/ fixed for the first few years and after that, the rate may adjust accordingly.
Payment-option ARMs: A payment-option ARM allows the borrowers to choose among several payment options every month depending on their capability of paying back mortgage amounts.
Negative amortization typically means that the amount an individual owes increases even when the borrower makes the required payments on time. It happens when the monthly mortgage payments are not adequately enough to pay the interest amount that is due on the mortgage. This means that the unpaid interest will get added to the total principal on the mortgage, and hence the individual will owe more than the borrower originally borrowed. Some ARMs, especially the interest-only and also the payment-option ARMs, might also require the individual to pay special additional fees or any penalties if one actually pays off the ARM early much before the expiry of the loan. It is then left to the lender to decide whether the consumer is to be charged with hard/soft prepayment penalties. Considering these, choosing a mortgage option is one of the most important financial decision a borrower should make.
Significant use of ARMs (Adjustable Rate Mortgages) by the financial institutions and banks before 2007-08 led to the worst ever financial crisis. Many lenders offered ARM’s with an initial rate that was lesser than the fully indexed ARM rate. Due to lower interest rates in the beginning and very high interest rates later led to payment shock for the borrowers which resulted in increase in number of defaults. This led the fall of the housing market in USA during 2007-08.