Here’s how they work:
Initial Period: When you first take out the loan, you’ll enjoy a fixed interest rate for a specific period. This can be anywhere from just one month to as long as ten years! Typically, the initial rate is lower than what you'd find with a fixed-rate mortgage, making it easier for you to buy a more expensive home.
How Do ARMs Work?
After the initial fixed-rate period ends, the interest rate on your ARM adjusts based on current market conditions. Let's break down the key components:
The Margin: This is the percentage that lenders add to the index when it's time to adjust your rate. Margins typically range from about 1.75% to 3.5%. It can depend on various factors, like the loan amount relative to the home's value.
The Index: This is a benchmark that can influence your interest rate. Common indices include:
- 1-Year Treasury Security
- LIBOR (London Interbank Offered Rate)
- Prime Rate
- 6-Month Certificate of Deposit (CD)
- 11th District Cost of Funds Index (COFI)
When Do Rates Change?
When it’s time for your ARM to adjust, the lender adds the margin to the index rate, usually rounding it to the nearest 1/8 percent to determine your new interest rate. This new rate will then be fixed for the upcoming adjustment period.
For example, let’s say you have a "3/1 ARM" (this means your rate is fixed for the first three years). If your initial interest rate is 6.25% and your loan has:
- An initial cap of 2% (meaning your rate can’t go up more than 2% after the initial period)
- A lifetime cap of 6% (meaning your rate can never exceed 6% above your starting rate for the life of the loan)
Then, in the fourth year, the highest your interest rate could reach would be 8.25% (6.25% + 2%). And throughout the life of the loan, it wouldn’t exceed 12.25% (6.25% + 6%).
Why Choose an ARM?
ARMs can be a great choice if you plan to stay in your home for a relatively short time or if you're banking on a rise in your income over time, as the lower initial rate can be very appealing. Just be sure to carefully consider the potential for higher payments down the line!