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Derek Bissen, May 12 2022

​ARM Loan Financing – Everything You Must Know

Have you ever heard of a ARM loan and thought, “what is that?”  Keeping it simple, AN ARM LOAN IS SHORT FOR ‘ADJUSTABLE RATE MORTGAGE”.  ARM loans can be an extremely useful financial tool in certain circumstances.  

In this article we’ll cover the fundamentals so you will have a full understanding of how this type of home loan works, so you can decide if this is the best type of financing for your needs and goals.

WHAT IS AN ARM LOAN?

Although the majority of home loans these days are 30 year fixed rate terms, from time to time you may encounter “ARM” loan financing.  ARM loans can often have lower interest rates than a fixed-rate loan counterparts. An ARM loan is simply a home loan with a 30 year payment schedule, where the interest rate is fixed for a certain number of years at the beginning of the loan. After the fixed period is over, the loan enters an adjustment period, where the interest rate adjusts one time each year and can move up or down with the market, until the loan pays off in full in 30 years.  Again, this is a loan that is designed to pay off in 30 years, so there is no lump sum balance due at the end of the fixed rate period (sometimes called a ‘balloon’.) 

WHAT ARE THE BENEFITS OF ARM LOAN FINANCING?

ARM loans can have their advantages.  When a lender is lending outside the traditional underwriting guidelines of a traditional home, such as a Conventional home loan, the lender may elect to lend using ARM financing, to mitigate the overall risk of the loan.  This allows the lender the freedom to be more flexible than they might otherwise be with a more traditional loan program.

Here is a list of some of the common circumstances where ARM loans are most beneficial:

HOW DOES AN ARM LOAN WORK?

As we discussed earlier, an ARM loan is simply a 30 year loan that has an interest rate that is fixed for the first several years at the beginning of the loan. After those first several 'fixed rate' years have elapsed, the loan enters it's adjustable rate period, where the interest rate and monthly payment of the loan can change over time. When it comes to ARM loans, the most important thing you need to know is HOW the loan can change over time. If you have a working understanding of this, then you can the confidence to know if this is the right type of loan for your goals.

BASIC "ARM LOAN" TERMINOLOGY

Before we get into the details, let’s cover a few basic terms you’ll need to know so everything will make sense.

CAPS: YOUR PROTECTION AGAINST SKYROCKETING INTEREST RATES AND MONTHLY PAYMENT SHOCK

Here’s how interest rate Caps work: Like all ARM loans, you have protections against future skyrocketing interest rates called CAPS.  If interest rates rise significantly during the life of the loan, the CAPS will set a maximum that your interest rate and monthly payment can rise over time.

The caps are shown in a series of 3 numbers. (EXAMPLE: "2/2/6" or "5/2/5")

The ‘floor’ of the loan is CAP that defines the lowest interest rate you will ever see on the loan, regardless of what happens to the index. In most cases, the floor is equal to the start rate, so if your interest rate started off at 5%, then 5% would likely be the lowest rate you could see on your loan.  

Let’s look example, based on one our most popular ARM loan programs, our own 5/1 ARM program. 

Here are the details of our 5/1 ARM program looks like.

HERE’S HOW YOUR LENDER CALCULATES YOUR INTEREST NEW RATE WHEN THE LOAN ENTERS THE ADJUSTMENT PERIOD:

This is the most important phase, and here is how the annual adjustment phase works. 

So now that we’ve covered the CONCEPT, here’s an example using our 5/1 ARM Program:

EXAMPLE SCENARIO: 5/1 ARM with a start rate of 4.25%.

At the end of 5th year, the lender researches the index (the 1 year US treasury index) and determines that the index is at 4.5%.  The margin of 2.75% is added to this figure, for a total of 7.25%. 

In theory, you might think that 7.25% would be the new interest rate; however in reality, THE NEW RATE WILL ONLY RISE TO 6.25%.  Why is this?  Because the loan has an annual rate cap protection of 2% from the previous year’s interest rate. (original start rate of 4.25% + the CAP of 2% = 6.25%) and the caps ensure that you receive the lower of two rates  (6.25% being lower than 7.25%)

This process repeats each year until the loan pays off in 30 years, or whenever the loan is paid in full, whichever comes first.

Since this loan has a lifetime cap of 6, it means that your interest rate can never rise above 10.25%, which is 6% higher than the start rate of 4.25%. 

DOES AN ARM LOAN MAKE SENSE FOR YOU?

Here are few basic questions to ask yourself to determine if and ARM Loan is the right program for you:


There you have it!  We hope you found this helpful and informative. If you have additional questions, we would be delighted to discuss your scenario with you and answer any questions your may have.

If you’re looking to purchase refinance, or get preapproved to purchase your next home—anywhere in the state of Florida, we’d love to assist you.  CONTACT US or give us a call today!

HERE IS A LIST OF OUR MOST POPULAR PROGRAMS THAT OFFER ARM LOAN TERMS:


Written by

Derek Bissen

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