TEXAS FIVE STAR LENDER

Adjustable-Rate-Mortgage (ARM) loans

An adjustable-rate mortgage (ARM) is a home loan with an interest rate that is flexible and subject to adjustment on specific dates or based on certain market conditions. This means that the monthly payments can go up or down.

Generally, the initial interest rate could be lower or higher than that of a comparable fixed-rate mortgage. After that initial period ends, interest rates — and your monthly payments — can rise or fall.

An ARM can be beneficial for homebuyers looking to keep the loan for a limited period and/or who can afford the potential increase in interest rate over time.

What are the requirements for an adjustable-rate mortgage?

The basic requirements for an ARM loan include a credit score of at least 620 and a debt-to-income ratio (DTI) of 50 percent or less. Further requirements depend on whether you get a conventional, FHA or VA or an ARM loan.

Types of ARMs

ARMs are generally 30-year mortgages, but they can vary a lot in how often the fixed rate lasts and how often the rates change once you’re into the variable-rate period. Here are the some typical loan terms:

F/A ARM. e.g., 3/6 and 3/1 ARMs: 3/6 and 3/1 ARMs have a fixed (F) introductory rate for the first three years of the mortgage, then switch to an adjustable rate for the remaining 27 years. 3/6 ARMs adjust (A) every six months, whereas 3/1 ARMs adjust (A) yearly.

ARM Loan Cap Structure:   M/N/P ARM Loan Cap Structure:
The first number, M, is the initial cap. This means the number of percentages points your rate can increase when it first starts adjusting.

The second number, N, is the periodic cap. This is the number of percentage points your rate can increase with each adjustment after the first one.

The third number, P, is the lifetime cap. This is the total number of percentage points your rate can increase over the life of the loan.

Example: 5/1 ARM Loan Payment with 2/2/5 Cap structure for initial borrowing amount of $450,000 with an initial interest rate of 6.25%.

If you don’t refinance to a fixed rate before your ARM resets, you could pay an extra $609.97 per month on your mortgage payment with the first adjustment. In the worst-case scenario, the monthly payment would jump up by $1,599.95 in the remaining of the loan time.

Time since the original loan closed. How long you’ll have to wait to refinance varies based on your loan program and what type of refinance you’re seeking. 

If you’re worried about your interest rate changing in the future but need the flexibility of a lower initial rate, ask your lender whether they offer an ARM loan with a conversion option. This allows you to “convert” your loan to a fixed rate in the future without having to refinance. There may be a fee to use the conversion option, so make sure you understand how any conversion clause works and how much it costs.

What index is used with a 5/1 ARM?

The index is important to understand because it’s the “moving” part of your adjustable rate and fluctuates with changes in the market. Your lender decides which index will be used. Most current ARM programs use the Cost of Funds Index (COFI), the one-year Constant Maturity Treasury (CMT) securities index and SOFR (Secured Overnight Financing Rate). The SOFR Averages are compounded averages of the SOFR over rolling 30-, 90-, and 180-calendar day periods.

You may hear the term “fully indexed,” which simply refers to how much your rate will be when your margin and index are added together. To find out what your fully indexed rate would be, you simply add the current index rate to your margin. For example, if the CMT index rate is currently 2%, and your margin is 5%, then your fully indexed rate would be 7%.

Interest-only ARM

Interest-only ARMs are adjustable-rate mortgages in which the borrower only pays interest (no principal) for a set period. Once that interest-only period ends, the borrower starts making full principal and interest payments.

The interest-only period might last a few months to a few years. During that time, the monthly payments will be low (since they’re only interest), but the borrower also won’t build any equity in their home (unless the home appreciates in value).

Payment-option ARM

With a payment-option ARM, borrowers select their own payment structure and schedule, such as interest-only; a 15- 30- or 40-year term; or any other payment equal to or greater than the minimum payment. (The minimum payment is based on a typical 30-year amortization with the initial rate of the loan.)

A payment-option ARM, however, could result in negative amortization, meaning the balance of your loan increases because you aren’t paying enough to cover interest. If the balance rises too much, your lender might recast the loan and require you to make much larger, and potentially unaffordable, payment.