An ARM is short for Adjustable Rate Mortgage. The adjustable rate mortgage has received a bad rep over the past few years as it has caused many home owners to foreclose. However, if looking for an interest rate feature that initially allows for lower interest rate payments and adjusts over the life of the loan, an adjustable rate mortgage might be a good fit. The interest rate on an ARM is lower in the beginning and it increases or changes as the loan term continues. If income is expected to rise in the future or if not planning to live in the home for a long time, an adjustable rate mortgage can be very attractive.
How frequently the interest rate is adjusted depends on the term of the loan. Adjustable rate terms can be anywhere from 6 months, 1 year, 2 years, 3 years, 5 years, or even 7 years and in some cases can even be some other loan term. Usually, there is a period of time that the interest rate will stay the same with no increases. This could be anywhere from a few months to several years, depending on the ARM.
How much can the interest rate fluctuate or adjust over the loan term? Most ARM’s have annual and lifetime caps. This means that the interest rate will not increase over and above a certain percentage, within a specific period of time. For instance, an interest rate on an adjustable rate mortgage with a 1.5% annual cap cannot increase by more than 1.5% each year and an ARM loan with a 5% lifetime cap can never have a rate higher than 5% over the starting interest rate of the adjust rate mortgage.
Let’s look at a couple ARM loan scenarios. A 5 year ARM would mean that the original interest rate would stay the same for the first 5 years of the term and then each year, the interest rate would increase (not more than the annual cap), beginning with the 6th year and so on. A 1 year adjustable rate mortgage would have the same set of features, allowing for the interest rate to start increasing during year 2, year 3, year 4, etc. In each case, the entire loan term and the interest rate increases will not exceed the lifetime cap.
In most cases, adjustable rate mortgages can be refinanced as well. If the interest rate begins to increase on the ARM, refinancing would offset some of the interest rate risks associated with the ARM.
Finally, similar to the adjustable rate mortgage is a balloon mortgage. The balloon mortgage product offers an interest rate that is usually less than a fixed-rate mortgage and is low during the initials years of the loan term, but must be paid in full with a final balloon payment at the end of the loan term. Common balloon loan terms range from 5 year to 7 years. Balloon loans are attractive if planning to sell in the near future, pay off the mortgage, planning to refinance, or expecting to receive a large sum of cash in the future.