Unlike fixed rate mortgages with a rate of interest that remains the same for the life of the outstanding loan, the interest rate on an ARM will change occasionally. The initial interest rate of an ARM is lower than that of a fixed rate mortgage, hence, an ARM could be an excellent option to consider if you’re planning to own your residence for only a couple of years; you anticipate a rise in future earnings; or, the prevailing interest rate for a fixed rate mortgage is too high.
When the original interest rate period has expired, the brand new interest rate is figured by including a margin to the index. Your lender will disclose the margin at time of loan application (margins can vary from lender to lender, so that it’s wise to search about for a margin that is low). As the index amount moves up or down, your interest rate will be corrected accordingly. Decreases or increases in the rate of interest will likely be limited by your loan’s interest rate cap construction.
Some protection is provided by the interest rate cap structure from interest rate swings that are large. There are two types of caps: (1) yearly, and (2) life-of-the-loan. The annual limit restricts the amount your rate of interest can change, up or down, in any given year, while the life-of-the-loan limit limits the maximum (and minimum) interest rate you are able to pay for so long as you’ve the mortgage. FHA offers a regular 1-year ARM and four “hybrid vehicle” ARM products. Hybrid ARMs offer an initial interest rate that’s constant -, 5-, 7-, or 10 years. Following the first period, the interest rate will adjust annually. Below are the various interest rate cap constructions for the many ARM products:
1-year ARM and 3-year hybrid ARM have yearly caps of one percentage point, and life-of-the-loan limits of five percentage points. (Example – if your initial interest rate was 5.00%, the greatest potential interest rate would be 10.00%)
5-, 7-, and 10-year hybrid ARMs have annual limits of two percentage points, and life -of-the-loan caps of six percentage points.