Adjustable-Rate Mortgage (ARM)
What it is:
As you can see, ARMs can have complex implications. Thus, as is the case with any loan, borrowers must be sure to read and understand the lender's documentation and contemplate the implications of changes in margins. Borrowers should be sure they can handle the worst-case scenario of being forced to make the highest mortgage payments allowed. Lenders are legally required to disclose how high the borrower's monthly payment might go.
How it works/Example:
The idea behind ARMs is very simple, but there are many covenants that can be included in the contracts to complicate things. Two common types of ARMs are the interest-only ARM and the hybrid ARM. Interest-only ARMs offer a set period during which the borrower only pays the interest on the loan. This reduces the borrower's payment, but it leaves the principal outstanding. Hybrid ARMs offer a fixed interest rate for a period of time and then revert to a variable rate for the remainder of the loan's life. A 3/1 ARM, for example, is a mortgage that carries a fixed rate for the first three years and then adjusts every year thereafter.
In many cases, ARMs have caps -- limits on how high and sometimes how low the interest rate can go, and how much they can move in any one year, month, or quarter. In some cases, the interest rate will only adjust up -- that is, borrowers will get no benefit if interest rates fall.
To understand how adjustable interest rates affect a borrower's payment, let's assume that a bank offers a $100,000 ARM to a potential borrower. The interest rate is the prime rate plus 5% with a maximum of 10%. If the prime rate is 3%, then the borrower's interest rate is 8% (5% + 3%), and the monthly payment would be $733.77. But if the prime rate increases to, say, 4%, then the loan's interest rate resets to 9% (5% + 4%), and the payment is now $804.63.