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:
- Lower Interest Rates – Many ARM loan programs offer lower interest rates than a fixed-rate loan counterparts.
- Jumbo Home Loan sizes - ARM loans are commonly seen in larger (Jumbo) loan sizes ($1MM+), that exceed the Conventional loan size limits permitted by Fannie Mae (FNMA) and Freddie Mac (FHLMC). Check out our Our PRIVATE CLIENT PORTFOLIO PROGRAM offers extremely competitive pricing and flexible underwriting qualification for well-qualified applicants.
- Foreign Nationals – ARM loans are common when offering home loan financing with competitive terms to Foreign Nationals (citizens of other countries outside the US). Due to the increased risk to the lender, ARM loans help balance the high-risk nature of lending to a non-US citizen. Our FOREIGN NATIONAL PROGRAM is a especially helpful for financing these types of homes.
- Portfolio Loans with more Flexible Underwriting terms - ARM loans often offer more flexible loan terms than a traditional home loan, and lenders will often use ARM loans when they are permanently holding the servicing rights for the duration of the loan, also known as ‘portfolio lending’. Our PRIVATE CLIENT PORTFOLIO PROGRAM offers one of the most flexible Asset-based mortgage solutions available in the current marketplace, while offering extremely competitive terms--which is especially helpful for applicants with a sizeable liquid asset portfolio, but little taxable income on their income tax returns.
- Non-Warrantable Condominium and/or Condotel Financing - ARM loans often offer more flexible qualification standards than a traditional conventional home loan for Condominium approvals. Our PRIVATE CLIENT PORTFOLIO PROGRAM is a especially helpful for financing for all types of condos.
- Financing for Unique Home Types - ARM loans are often useful for buying specialty homes, such as a Barndominium, Hangarminiums, Log Homes, Large Acreage Luxury Homes, etc. Our PRIVATE CLIENT PORTFOLIO PROGRAM is a especially helpful for financing these types of homes.
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.
- NAME OF THE PROGRAM – This might seem obvious, but just knowing the name of the program itself is a great starting place, because this will tell you a great deal about the loan itself. For instance, a 5/1 ARM means that the program is a 30 year loan where the interest rate is fixed for the first 5 years. If it were a 10/1 ARM, then it would be a 30 year loan where the interest rate is fixed for the first 10 years.
- INTEREST RATE – This is the starting interest rate of the new loan.
- INDEX - the index is one of the TWO core components of your interest rate. An index is usually a publicly available number, such as the 1 year US Treasury Rate.
- MARGIN – the second component of your interest rate is the margin. It may be helpful to think of the margin as basically the bank’s profit margin’. The Index and margin, when combined, will guide what happens to your loan in the future.
- CAPS - The caps, or Interest Rate Caps, are your protection against skyrocketing interest rates and monthly payment shock in the future. (We’ll cover the caps in more detail in a moment)
- FLOOR – this is the lowest that your interest rate can go for the life of the loan. In most cases, the floor is the same interest rate as the start rate of the loan.
- CEILING – sometimes referred to the ‘Lifetime Cap”, is the HIGHEST that your interest rate can rise during the life of the loan.
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 FIRST digit in the sequence, defines the maximum that the interest rate can increase at the beginning of the adjustment phase of the loan, after the fixed period is over.
- The SECOND digit, defines the maximum rate increase (or decrease) you can expect in the remaining annual adjustment periods.
- The THIRD and final digit in the series, is known as the lifetime cap/ceiling. The lifetime cap is the highest your interest rate can rise during life of the loan.
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.
- This loan program has caps of 2/2/6, a margin of 2.75, and a floor rate equal to the start rate.
- The interest rate is fixed for the first 5 years and the monthly principle & interest payment remains the same for a full 5 years.
- On month 61, the loan enters the ‘adjustable phase’ of 25 years.
- The interest rate will adjust once every 12 months for the remaining 25 years and/or until the loan is paid off. The interest rate will trend upwards or downwards with the index (the 1 Year US Treasury index, which is available publicly online).
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.
- When the loan nears it’s annual adjustment phase, your lender will research the current index online (the 1 year US Treasury) at the time and then add it together with the bank’s profit margin (aka the ‘margin’), which is 2.75.
- The lender compare this number to the caps, and then whichever number is the LOWER of the two becomes the new interest rate for your loan for the next 12 month period.
- This process repeats each year until the loan pays off in 30 years, or until the loan is paid in full.
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:
- How long will I own this home and how long might I have this financing?
- Do the terms of the new ARM loan save me a significant amount of money for the duration of the time I want to keep the home?
- Does this program offer a level of qualification flexibility that I need that I cannot achieve with traditional fixed rate financing?
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: