What Are the 4 Components of an ARM Loan?

If you are looking for a new home, the current housing market’s high home prices and rising interest rates may have you seeking out alternatives to conventional, fixed-rate mortgages. 

An adjustable rate mortgage (ARM) loan can be a great option if you meet specific criteria: 

• You don’t intend to stay in the home very long.
• You plan to pay off the house quickly.
• You want low payments initially and are willing to risk a higher interest rate later.

If any of these scenarios fit into your homebuying strategy, an ARM might be the right mortgage for you. Ready to learn more?

What Is an Adjustable Rate Mortgage?

An adjustable rate mortgage is a home loan that offers a low fixed-interest rate for a set period of time. When that period ends, the loan’s interest rate adjusts up or down with current market conditions throughout the remainder of the term.  

There are three different types of ARMs: hybrid, interest-only*, and payment-only. However, many lenders only offer hybrid ARMs. Hybrid ARMs are distinguished by two phases: 

• The initial fixed-interest rate period, normally three, five, seven, or ten years
• The adjustable interest rate period, which continues for the remainder of the loan term

*FFB does not originate interest only loans

When you qualify for an ARM, your lender will designate the length of the initial period and how often they can change your interest rate each year during the adjustment period. For example, a 5/6 ARM has a fixed interest rate for five years, after which the lender can adjust your rate every 6 months. 

The Four Components of an ARM Loan

ARM loans comprise four separate components: the index, the margin, the interest rate cap structure, and the initial rate period. 

1. Index 

The index is a financial indicator that rises and falls based on market conditions. The variable index and your loan’s fixed margin are used as the basis of all future interest rate adjustments on the loan. 

There are several different indexes used to price ARM loans. During the application process, your lender will decide which index your mortgage will use throughout the life of the loan.

2. Margin

The ARM margin is a fixed number of percentage points that are added to the index to determine your interest rate when the initial period ends. This is known as the fully indexed rate. Margins can vary by lender and by loan, but once the margin is set in your loan agreement, it won’t change.

3. Interest Rate Cap Structure 

When the initial period ends and it’s time for your ARM to adjust, the new interest rate will be fixed for the duration of the set adjustment period. However, there are limits (or caps) on how much the rates can increase during an adjustment.

The interest rate cap structure protects borrowers against exorbitant rate hikes by providing a ceiling for maximum interest rate increases throughout the term of your loan:

• Initial cap: Limits how much your rate can increase during the first adjustment period.
• Periodic cap: Limits how much your rate can increase from one adjustment period to the next.
• Lifetime cap: Limits how much your rate can increase or decrease over the life of your loan.

4. Initial Interest Rate Period

The interest rate on your ARM loan is fixed during the initial period, and many lenders offer exceptionally low “teaser” rates to attract borrowers. The initial period can last anywhere from six months to 10 years; however,  the most common ARM terms have an initial period of five, seven, or ten years. When the initial interest rate period expires, your ARM loan moves into the adjustment period and your interest rate becomes variable for the remainder of the loan term.

At-a-Glance: Benefits and Drawbacks of an Adjustable Rate Mortgage

An ARM definitely isn’t right for every homebuyer, so it’s important to understand the benefits and drawbacks of these home loans before you move forward with a loan application. 

Benefits

• They provide lower interest rates than fixed-interest rate mortgages.
• They require lower monthly payments to start.
• Interest rates may drop during the adjustment period.
• Interest rate caps provide a ceiling for rate increases.

Drawbacks

• Monthly payments will fluctuate throughout the life of the loan.
• Your financial circumstances may change, making your mortgage unaffordable.
• Interest rates may go up during the adjustment period.
• Payment caps can cause negative amortization, which means your mortgage payment isn’t enough to cover the interest on the loan.

Learn More About Adjustable Rate Mortgages

ARM loans are more complicated than 15 or 30 year fixed rate home loans. Now that you have an understanding of the four components of an ARM loan, you can find a mortgage lender you trust to help you navigate the complexities, understand your options, and make informed decisions.  

Whether you’re ready to apply now for an ARM loan or you just want to learn more about the different types of mortgages, we’re here to help! Contact us today and a member of the FFB Mortgage Lenders team will be in touch.

(2) Disclosure of rates:

(i) In general. If an advertisement for credit secured by a dwelling states a simple annual rate of interest and more than one simple annual rate of interest will apply over the term of the advertised loan, the advertisement shall disclose in a clear and conspicuous manner:

(A) Each simple annual rate of interest that will apply. In variable-rate transactions, a rate determined by adding an index and margin shall be disclosed based on a reasonably current index and margin;

(B) The period of time during which each simple annual rate of interest will apply; and

(C) The annual percentage rate for the loan. If such rate is variable, the annual percentage rate shall comply with the accuracy standards in §§ 226.17(c) and 226.22.

(ii) Clear and conspicuous requirement. For purposes of paragraph (f)(2)(i) of this section, clearly and conspicuously disclosed means that the required information in paragraphs (f)(2)(i)(A) through (C) shall be disclosed with equal prominence and in close proximity to any advertised rate that triggered the required disclosures. The required information in paragraph (f)(2)(i)(C) may be disclosed with greater prominence than the other information.