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Adjustable Rate Mortgages or "ARM loans" are mortgage loans where the interest rate adjusts at certain predetermined intervals, and that allows the lender to periodically bring the interest rate closer to market, effectively having the borrower share some of the interest rate risk associated with making loans over the long term.
These components or provisions are typically outlined in an adjustable rate promissory note or an adjustable rate rider that is attached to the original promissory note.
The first component in the ARM loan is the adjustment interval. This determines how often the interest rate adjusts. Typically, we will see anywhere from monthly to semi-annually to annually to perhaps even longer intervals. The longer the interval, the more interest rate risk the lender keeps. The shorter the adjustment interval, the more interest rate risk is passed along to the borrower.
Adjustable rate loans typically have an initial interest rate, called a teaser rate, that is a more attractive, often extra low rate, that is unrelated to the composite rate that will be in place throughout the life of the loan.
Interest rates in adjustable loans are typically tied to an index. The index is the indicator of the market interest rates to which the loan is tied, and is what is used to help set the rate at each adjustment period. Common indices for adjustable rate loans in the United States are the Treasury Bills, the London Interbank Office Rate, or LIBOR, or the 11th District Cost of Funds, sometimes called COFI. Regardless, the index is the basis for the interest rate at each adjustment period.
Once the market rate from the index is determined, the lender adds what they call a margin to that index. This is the lender's premium over and above the market rate. The combination of the index plus the margin is referred to as the composite rate, and that's the new rate which the borrower will pay at the next adjustment interval.
Each adjustment interval occurs on the reset date, and that's the date when the interest rate and the payments are reset. Once the interest rate is reset and the new payment is calculated, the loan will also invoke what's called payment caps. A payment cap is a limit to how much a payment can go up in order for the borrower to not experience what's called payment shock. Often, the interest rate can go up more than one point at an adjustment interval, but there will be say a five or ten percent limit to how much the payment can go up. This can sometimes put us into a situation where we have negative amortization, and that's because interest is accruing at a rate faster than it's being paid down.
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