Question:

Can you define adjustable rate mortgage (ARM)?

Answer:

To define adjustable rate mortgage (ARM), it is enough to say that this is a mortgage which starts with a low fixed rate for a number of years, and after that the rate will adjust up or down, according to the index it is tied to.

Common adjustable rate mortgage plans are 5/1 ARM, 10/1 ARM, which means that the adjustable rate mortgage at hand will start with a five or ten year fixed rate, and after that the ARM rate will adjust once every year.

Some popular adjustable rate mortgage (ARM) indexes include:

  • 12-month Treasury Average Index (MTA)
  • Constant Maturity Treasury (CMT)
  • 11th District Cost of Funds Index (COFI)
  • London Interbank Offered Rate (LIBOR)

When defining adjustable rate mortgage, it is important to know most common features ARMs exhibit. For example, starting rate, adjustment frequency, margin, rate caps, conversion and prepayment.

Rate caps are defined as the adjustable rate mortgage rate maximum and minimum limits for the lifetime of the loan or of the periodic adjustments. For example, a lifetime rate cap of 6% on an ARM with 7.25% starting rate means the highest rate the loan can ever have is 13.25%. A periodic adjustment of 2% means that any time the ARM rate is adjusted, it cannot go up or down with more than 2%.

Conversion is the option given to the borrower to transform the ARM into an FRM at certain point.

Prepayment penalties are fees, calculated as monthly interest or percentage of the loan amount for the borrower to pay if they prepay or refinance their adjustable rate mortgage early.

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