Adjustable Rate Mortgages (ARM) offer borrowers a lower initial interest rate than traditional fixed rate mortgages, allowing individuals to purchase a more expensive property. ARMs are typically 30-year loans that have a fixed rate for an initial period of time that can be as short as 1 month and up to 10 years.
The interest rate on an ARM is determined by adding the loan's margin, typically ranging between 1.75% - 3.5%, and the index the loan is tied to. Popular indexes include the 1-Year Treasury Security, LIBOR, Prime, 6-Month CD, and the 11th District COFI. When the fixed period has expired, the new rate will become the margin plus the index, rounded to the nearest 1/8 of one percent. This change can occur annually and is subject to rate caps which limit how much the rate can rise. For example, a 3/1 ARM loan with an initial cap of 2%, lifetime cap of 6%, and initial interest rate of 6.25%, would have a highest rate of 8.25% in the fourth year and 12.25% during the loan's life.