Fixed-Period ARMs

A fixed-period adjustable rate mortgage is one simply a Adjustable Rate Mortgage with an initial fixed rate that lasts for a number of years (e.g. 3, 5, 7 or 10 years) after which the loan adjusts on a regular bases.

Regular adjustable rate mortgages have the interest rate charged linked to an economic index. When the index goes up the interest rate charged on the mortgage will increase (advantageous to the lender) but if the index goes down then the interest rate charged will go down (advantageous to the borrower).

A lender uses one economic index to adjust the interest charged. There are several economic indexes used by lenders to set the interest rate with a common index being one, three and five year Treasury bills.

As well as the economic index the lender charges a margin. This margin is fixed for the length of the mortgage.

As an example, if the index was 4% and the margin 2% then your interest rate would be 6%. If the index were then to change to 4.5% the margin remains 2% and the new interest rate on your mortgage would be 6.5%.

Fixed-period adjustable rate mortgages have a beginning period of several years (e.g. 3, 5, 7 or 10 years) during which the initial interest rate will not change, after this period the interest rate will change at regular intervals depending on what the index does. You decide on the beginning time period and the time period between adjustments. The longer the fixed-rate period the greater the risk to the lender so the larger the initial interest rate charged. Also, the shorter the time between adjustments the less risk to the lender and the lower the margin charged.

To protect the borrower from sudden changes in interest rates a couple of different types of limits are often used:

1. A maximum interest rate that can be charged. This interest rate is expressed as the maximum interest rate that the lender will charge the borrower, e.g. 19%.
2. An interest rate cap that limits the change for an adjustment period. If 5% is the agreed cap then the loans’ interest rate can only change within a 5% range for each adjustment period.

The mortgage interest charged will be at market rates but the borrower will only pay at the maximum or capped rate. In this case the payment will not cover the interest and the difference will be added to the principle, a process known as negative amortization.

Advantages:

• Because some of the risk is shared by the borrower the initial interest rate for an ARM is less than for a fixed rate mortgage. This will lower your initial monthly payments and may help you to qualify for a mortgage.
• You are protected against a rate increase for the first 3, 5, 7 or 10 years depending on the length of the fixed-period.
• If you aren’t going to stay in the house for a long period of time, the lower initial payments may be all that you pay with the adjustment period being set to happen after you move.
• If you expect your income to rise then the increase in earnings will cover any increase in the mortgage due to an increase in the index used.

Disadvantages:

• If the market interest rate increases past the maximum the lender can charge the borrower, the monthly payment will not cover the interest part of the mortgage. When this happens the lender adds the difference to the principal the result could be borrowers ending up with a larger mortgage than they started out with.