ARM stands for adjustable-rate mortgage. ARMs are mortgages where the mortgage interest rate resets at set periods to bring the interest rate in line with current market rates. Technically, an ARM loan does not come to an end until the loan is paid off. A homeowner with an ARM mortgage needs to understand the other time limitations involved with an ARM.
There are three periods of time that are important with an ARM. First, most ARMs are 30 year mortgages. This means that after making the monthly payment as planned for 30 years, the mortgage will be paid off, the ARM will end and the homeowner will own the home free and clear. Next is the ARM reset period. Most ARMs reset the interest rate of the loan once a year on the loan anniversary date. The final period is the initial or teaser period . Many ARMs are started with the interest rate fixed for three or five years. During that time the rate and payment will not change. At the end of the teaser period, the rate will start to adjust each year.
After the initial three- or five-year rate period, the interest rate and payment of an ARM will be adjusted to a new rate based on the terms of the ARM contract. The new rate and payment may be higher or lower than the previous levels. As the rate reset date approaches, the homeowner should have an estimate whether the new payment will be higher or lower than the current payment.
An ARM contract will specify how the mortgage interest rate is calculated when it is time to reset the rate. The new rate will be the current rate of a specified interest rate index plus a margin amount. The typical margin amount is 2 to 3 percentage points added to the index rate. Commonly used ARM indexes are the constant maturity one-year Treasury rate, the 11th District cost of funds and the one-year LIBOR rate. These rates are all indicators of current short-term interest rates.
Each monthly mortgage payment is divided between a payment of interest to the lender and principal to pay down the mortgage balance. As an ARM gets older, more of each payment goes to reduce the principal balance. The result is that in the early years of a ARM the annual interest rate reset may significantly change the monthly payment amount. In later years, interest rate changes will have a smaller effect on the payment.
Individuals looking at a new ARM to buy or refinance a home should be aware of an initial teaser rate. The starting rate on ARMs is often set below the market rate. Ask the mortgage loan officer to calculate what the payment would be if the loan was at the contract index and rate. The mortgage payment should still be affordable to the buyer's budget at the fully indexed payment level. Buyers who take out an ARM with a below-market rate for the first few years can add some additional principal payment to each monthly payment. This will prepare them for a higher payment when the rate resets and start to pay down the loan balance faster.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.