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Adjustable Rate Mortgages (ARMs) Explained

Adam Ferguson

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Quick Explanation of Adjustable Rate Mortgages (ARMs)

Have you ever wanted to know the details of adjustable rate mortgages?  This can be a confusing topic for folks that have not spent some time to research the different types of mortgages.   There are quite a few different types of adjustable rate mortgages.   Within each type of ARM there are different options, such as an interest only adjustable rate mortgage.   Hopefully this quick reference will help you determine if an adjustable rate mortgage is right for you.

Fixed Period ARMs - 3/1, 5/1, 7/1, and 10/1 ARM

These hybrid ARM loans have an initial fixed period that will be determined by the program you select. The first number represents the number of years the rates are fixed. The second number indicates the adjustment interval (how often the interest rate will change in the adjustable phase of the loan). For a 7/1 loan, the fixed period is seven years with annual interest rate adjustments thereafter. These loans carry a 30 year term.    

Interest Only Loans - 3/1, 5/1, 7/1, and 10/1 ARM   

These programs work in the exact same manner as the Fixed Period ARM loans explained above with one exception. During the initial fixed period the minimum required payment is an interest only payment. At the end of the fixed period, the loan will adjust one time per year and require a fully amortizing (principle and interest) payment over the remaining loan term.  

Pay Option ARMs  

These programs provide the homeowner a very low start rate for usually one month or three months with the option of 4 different payments thereafter. After the initial fixed period (1 to 3 months) the loan becomes a monthly adjustable rate loan and the rate will be determined each month by adding the program index (Cost of Funds Index (COFI) and Monthly Treasury Average (MTA) are the most common) to the predetermined fixed margin.

The payment options are as follows: a low minimum payment based on the start rate, an interest only payment, a 30 year amortized payment and a 15 year amortized payment. The minimum payment is less than the actual interest accrual so you need to be aware that when making the “minimum payment" on this loan the monetary difference in the interest only payment and the minimum payment will defer to their principle loan balance every month, therefore, increasing the principle loan balance. This is sometimes referred to as deferred interest or negative amortization.

These loans typically will carry a 1 to 3 year prepayment penalty. If the loan is paid off (through a refinance or sale) within that prepayment penalty term, the penalty is normally 80% of 6 months interest on the outstanding principle balance.  

If you have additional questions on any of these ARMs you should contact a mortgage professional. You should never make a mortgage decision without weighing all of your options and knowing all of the small details about the mortgage that you are seeking. An adjustable rate mortgage needs to be completely understood before you make that final decision.


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