How Does An Adjustable Rate Mortgage ARM Work?

Mortgage Questions – How Does An Adjustable Rate Mortgage Work?

September 20th, 2011 |

Author: yroth

I get a lot of questions asking how an adjustable rate mortgage also known as an ARM works.

Here’s the mortgage answer.

The adjustable rate mortgage rate is fixed for a certain amount of time: either 3 years, 5 years, 7 years, or 10 years. After that fixed period is up the mortgage rate and payment will adjust.

What will the mortgage rate adjust to?

The adjustable mortgage rate will adjust to the yield on a specific index - most commonly is the LIBOR (London Interbank Offered Rate) index PLUS a margin. The margins range from 2.25% to 2.75%. So if the yield on the LIBOR index is 2% and the margin – which is fixed and can never change – is 2.25%, your bill mortgage rate will be 4.5%. Pretty easy.

Let’s say that you’re in a 5/1 ARM. The 5 stands for the amount of years the mortgage rate and payment are fixed. The 1 means that your mortgage rate can change every 1 year thereafter until the loan is paid off.

Adjustable rate mortgages are amortized over a 30 year term.

So to use the previous example of the 5/1 ARM, your mortgage rate is fixed for 5 years, after which time it will adjust one time a year. The ARM rate will adjust on an “anniversary date” until the mortgage is paid off.

Let’s say the “anniversary date” is April 1. So every April 1, the mortgage rate will reset to the yield on the LIBOR index – which moves and is variable – plus the margin – which is fixed.

How high can the mortgage rate go?

The mortgage rate on the adjustable rate mortgage is capped. The most common “cap structure” is called a 5/2/5 cap structure.

What this means is that the mortgage rate can move up to 5% over the start rate, which is the mortgage rate you had for the fixed period. Once the first adjustment is made to the mortgage rate, it’s fixed for one year. Then on the mortgage “anniversay date,” the mortgage rate will adjust again, but cannot increase more than 2% per year for every year thereafter.

No need to panic, as the last 5 in the 5/2/5 represents the lifetime mortgage rate cap on loan. So if the start rate was 4%, the most the mortgage rate can increase over the life of the loan is to 9% (i.e. 4+5=9).

So the interest rate may creep up 2% ever year after the fixed rate period lapses, but it cannot exceed 5% over the start rate.

Here’s an example: 5/1 ARM.

The start rate is 4% and is fixed for 5 years. After the 60th month, the mortgage rate goes to to yield on the LIBOR index plus the margin. Let’s say the LIBOR is at 4%. So, 4% plus the margin (let’s say 2.25%) is 6.25%.

The mortgage rate is now 6.25% for the 6th year of the mortgage.

Now going into the 7th year, let’s say the LIBOR index is at 8%. 8% plus the margin of 2.25% equals 10.25%. However, the 2% yearly mortgage cap will limit the rate to 8.25%. That mortgage rate and payment are fixed for the 7th year.

Going into the 8th year, let’s say the LIBOR is at 8.5%.

8.5% plus 2.25% = 10.75% however the most your mortgage rate can increase is to the lifetime cap of 9% (which was the inital 4% start rate plus the 5% cap.)

This is how an adjustable rate mortgage works.

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