What is an Adjustable-Rate Mortgage (ARM)?
An adjustable-rate mortgage (ARM) comes with variable interest rates based on each period’s outstanding balance on the loan. Initially, an ARM would yield a fixed interest rate for a period of time. After the period’s passed, the interest rate resets yearly or monthly and adjusts in accordance with the balance.
The interest rate of an adjustable-rate mortgage restarts based on an index, along with an adjustable-rate mortgage margin, which is the additional spread that stems from the amount of interest the borrower must pay on an ARM that is above the index rate.
Key Features of Adjustable Rate Mortgages
The three important features that should be recognized when issuing an ARM are:
1. Introductory rate
2. Actual rate
3. Conversion option
In the beginning, lenders will offer an introductory rate that is below their prime rate for a fixed time. After that period’s ended, the ARM will convert to an indexed rate that’s been agreed upon. It is referred to as the actual rate.
In many cases, some lenders will allow the borrower to convert their adjustable-rate mortgage from a variable rate into a fixed rate after the introductory period. However, additional costs may be incurred.
How Adjustable Rate Mortgages are Structured
ARMs are structured using an amortization schedule, which records and provides the lender with cash flows through paid installments. As rates rise, the adjustable aspect of the ARM (index) increases, which ultimately benefits the lender by generating more income through interest. Vice-versa, adjustable-rate mortgage loans would be beneficial to borrowers when rates are decreasing.
Exploring ARM Margins and Its Relevance to Credit Scores
The ARM margin is an addition to the index rate to determine the fully indexed interest rate that the borrower must pay on the loan. To find the two values, it is mentioned on the loan’s credit agreement when issued.
Depending on the credit score of the individual who is borrowing the ARM, he or she can expect to receive a lower ARM margin, which would generate a lower interest rate on the loan. It would result in lowered required interest payments; hence, it would benefit the borrower.
On the other hand, individuals with a poor credit score would incur a higher ARM margin, which would raise the interest rates on the loan received. It would then lead to higher costs, as they must pay higher interest expenses.
Annotations of ARM
Adjustable-rate mortgages are often depicted using two values. The first number indicates the length of time for the fixed-rate that is applied to the loan, while the second number represents the length of time for the variable rate.
For example, Bob purchases a loan for a home with an ARM valued as 5/10. It implies that Bob’s adjustable-rate mortgage comes with a fixed rate for five years followed by a variable rate that adjusts every ten years.
Variable Interest Rates
The variable interest rate consists of two components – an index and a margin. The index used as a measure for mortgages is one of the following three:
1. 1-Year Treasury Bills
2. 11th District Cost of Funds Index
Throughout time, the index rate can fluctuate; however, the margin will stay constant for an ARM. For example, Jon purchases a mortgage that yields an adjustable interest rate of 8%. Of the total interest rate, 5% stems from the index, while 3% is from the margin. Over time, the interest rate adjusts to 7%, where the index would shift down to 4%, while the margin would consistently maintain a 3% rate.
Uses and Limits of ARM
Adjustable-rate mortgage loans tend to be a popular product when buying homes. Homebuyers who plan to settle their debt in full and will not be affected or phased by variable interest rates may consider purchasing an ARM.
ARMs offer an upside potential but inherently yield downside risk if not managed properly. Often, ARMs come with floors and ceilings (limits) on how much the rate can rise, which narrows the volatility of payment changes.
The limits can be established on a monthly, periodic, or lifetime basis. Monthly limits specify how much monthly mortgage payments can rise. Periodic limits set the boundaries of interest rate changes on a yearly timeline. Lifetime limits cap how frequently the interest rate can rise over the life of the mortgage.
CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.
In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful: