What is an Adjustable Rate Mortgage, ARM, and who can benefit from it

Real Estate Broker/Owner with Texas Five Star Realty, Plano Texas

What is an Adjustable Rate Mortgage (ARM) and who can benefit from it?


Adjustable Rate Mortgages (ARM) Adjustable Mortgage Rate ARM1-Year ARM, Caps of 2/6?

An Adjustable Rate Mortgage is a mortgage loan in which

·         The interest rate adjusts periodically according to a predetermined index and margin.

·         The adjustment of the interest rate results in the mortgage payment either increasing or decreasing.

·         Periodic adjustments to the interest rate can occur every six months, every year or in multiple years.

·         ARMs typically have a lower initial interest rate vs. fixed.

·         There are ARMs that have fixed periods for 3, 5, 7 or even 10 years before the interest rate starts adjusting (Hybrid ARM)

ARM Terminology


Initial Rate The rate at which an ARM program begins is called the initial rate. The initial rate and payment amount on an ARM will remain in effect for a limited period of time. The initial rate can range from 1 month to 5 years or more.


Adjustment Period

The interest rate and monthly payment change every month, three months, six months, 1 year, 3 years, 5 years or 7 years or so. The period between rate changes is called the adjustment period. For example, a loan with an adjustment period of 1 year is called a “1-year ARM” and the interest rate and, therefore, payment can change once every year. Remember, the interest rate’s change could be positive or negative, it means at the next adjustment period, depending on the market, the interest rate could be higher or lower than the existing interest rate.



The index is what the lender uses as an instrument for measuring changes in interest rates. It is the lender’s barometer of change in interest rates. Increases or decreases in the index cause the ARM payment to increase or decrease accordingly.

Prevailing indexes include:

• 1 Year Constant Maturity Treasury Rate (CMT)

• 11th District Cost of Funds Index – COFI.
            It is also known as San Francisco 11th District Cost of Funds Index – COFI.
is often used as an index for adjustable-rate mortgages          

• London Interbank Offered Rate - LIBOR



The percent added to the index in order to calculate the payment interest rate. The Margin is the profit the lender will make above the index. The margin never changes during the life of the ARM.


Fully Indexed Rate

The fully indexed rate is equal to the margin plus the index and is usually to the nearest one-eighth of a percent. For example, if the lender uses an index that currently is 1% and adds a 2% margin, the fully indexed rate would be:


Index                           =1%     +
Margin                        =2%
Fully Indexed Rate    =3%

Discounted Initial or Indexed Rate (“teaser rate”)

If the initial interest rate on the loan is less than the fully indexed rate, it is called the discounted initial or indexed rate. A lower interest rate is offered by the lender during the first year or more of the loan. These interest rate concessions are used as incentives to attract borrowers to ARM products.


Interest-rate caps

An interest-rate cap places a limit on the amount the interest rate can increase or decrease. Rate caps limit how much interest can be charged. Interest caps come in three types:


Per Adjustment Cap

·         This caps limits how much a payment may increase or decrease in any subsequent adjustment. In most cases, lenders base the per adjustment cap off the initial or start rate. No matter what the Index + Margin calculates to at the time of adjustment, the per adjustment cap applies.


Lifetime Cap

·         This cap is the limit the interest rate increases over the life of the loan. This is a worst case scenario. The highest the payment will ever go to no matter what the Index and Margin add up to.


Initial Adjustment Cap

·         ARM’s that offer a fixed rate period during the first years of the loan usually have an initial rate cap that is higher than the per adjustment cap. In many ARM’s the interest payment rate may increase as much as 6% higher than the first year rate.


ARM Cap Terminology

1/4 ARM – 1% per adjustment cap and a 4% lifetime cap

2/6 ARM – 2% per adjustment cap and a 6% lifetime cap

4/2/6 ARM – 4% initial adjustment cap, 2% per adjustment cap and a 6% lifetime cap


Example: 1-Year ARM, ARM Caps of 2/6.  How does the ARM work?

The 11th District Cost of Funds (COFI) is often used as an index for adjustable-rate mortgages. At the time of writing this article, the COFI rate was 0.999%. Let’s assume 1%

If the index is 1% and the lender’s margin is 2% on a 1-year ARM, the fully indexed payment rate would be 3% (1% + 2%) during the first year.

If the caps are 2/6, the most the interest rate could move up after the first year would be 5% (3% initial rate plus 2% adjustment cap). Depending on what the index does after the first year, the actual interest rate could in fact be lower, but the maximum it could adjust upward is 5%.

Also, the maximum the interest rate could move for the entire life of the loan would be 9% (3% initial rate plus 6% lifetime cap). If the index increased the maximum every year, the borrower could reach the 9% maximum in the 4th year (this is the worst case scenario).

Maximum ARM interest rates for each perioed


Advantages of ARM Loans


1.    Lower initial interest rate:
The initial rate of interest will almost always be considerably lower than the best fixed rate mortgage deal in the short-term. Please note and emphasize on the key points here: ARM Initial rate for a short period of time will be lower than the best fixed rate at the time.


2.    The low initial low ARM can help borrowers who are currently struggling, but are confidence to experience income growth later in their professional career.


3.    Higher Loan Amount: The low introductory or initial rate allows a home buyer to borrow a larger sum of money and purchase their dream home because home mortgage payments are initially considerably lower.

4.    If Rates Falling: If the interest rates fall or stay low at the time of Adjustment Period, the home buyer benefits financially. The more rates fall down or the longer they stay low, the more financial benefit to home buyer.


Disadvantages of ARM Loans


1.    More Long Term Cost:
While the initial interest rates are lower than rates on fixed-rate loans, an ARM mortgage loan could actually cost the borrower much more over the full duration.


2.    Unpredictable Home Mortgage Payment: Unlike the fixed-rate mortgage interest, the rate of interest is not set and could go up a lot during the loan term. This could make it difficult for those who are on a fixed income to cope with rising payments when banks rates start to go up.
Warning: More Foreclosure. For the above reason, foreclosure rates have always been a lot higher on ARM’s than fixed-rate deals.


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Bahman Davani, CM at Texas Five Star Realty, Plano, TX (214) 457-7055

Homes for Sale in Plano, Frisco, Prosper, Allen TX
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