A mortgage on which the interest rate can be changed by the lender. While ARM contracts in many countries abroad allow rate changes at the lender's discretion, in the U.S. rate changes on ARM's are mechanical. They are based on changes in an interest rate index over which the lender has no control. Henceforth, all references are to such Indexed ARM's.
Reasons for Selecting an ARM: Borrowers may select an ARM in preference to a fixed rate mortgage (FRM) for three reasons:
1) To qualify: they need an ARM to qualify for the loan they want.
2) To take advantage of low initial rates on ARM's and their own short time horizon: they expect to be out of their house before the initial rate period ends.
3) To gamble on future interest rates: they expect that they will pay less on the ARM over the life of the loan and are prepared to take the risk that rising interest rates will cause them to pay more.
How the Interest Rate on an ARM Is Determined: There are two phases in the life of an ARM. During the first phase, the interest rate is fixed, just as it is on an FRM. The difference is that on an FRM the rate is fixed for the term of the loan, whereas on an ARM it is fixed for a shorter period. The period ranges from one month to 10 years. At the end of the initial rate period, the ARM rate is adjusted. The adjustment rule is that the new rate will equal the most recent value of a specified interest rate index, plus a margin. For example, if the index is 5% when the initial rate period ends, and the margin is 2.75%, the new rate will be 7,75%. The rule, however, is subject to two conditions.
The first condition is that the increase from the previous rate cannot exceed any rate adjustment cap specified in the ARM contract. An adjustment cap, usually 1% or 2% but ranging in some cases up to 5%, limits the size of any interest rate change.
The second condition is that the new rate cannot exceed the contractual maximum rate. Maximum rates are usually five or six percentage points above the initial rate. During the second phase of an ARM's life, the interest rate is adjusted periodically. This period may or may not be the same as the initial rate period. For example, an ARM with an initial rate period of five years might adjust annually or monthly after the five-year period ends.
The Quoted Interest Rate: The rate that is quoted on an ARM, by the media and by loan providers, is the initial rate�regardless of how long that rate lasts. When the initial rate period is short, the quoted rate is a poor indication of interest cost to the borrower. The only significance of the initial rate on a monthly ARM, for example, is that this rate may be used to calculate the initial payment.
The Fully Indexed Rate: The index plus margin is called the 'fully indexed rate,' or FIR. The FIR based on the most recent value of the index at the time the loan is taken out indicates where the ARM rate may go when the initial rate period ends. If the index rate does not change, the FIR will become the ARM rate.
For example, assume the initial rate is 4% for one year, the fully indexed rate is 7%, and the rate adjusts every year subject to a 1% rate increase cap. If the index value remains the same, the 7% FIR will be reached at the end of the third year.
The FIR is thus an important piece of information, the more so the shorter the initial rate period. Nevertheless, it is not a mandated disclosure and loan officers may not have it.