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The Adjustable Rate Mortgage (ARM) has a fixed adjustment period that is explained in the mortgage note. Many lenders attach an ARM addendum to the mortgage note clarifying unique ARM terms.
An addendum to the "Deed of Trust" or "Mortgage" describing the ARM terms will be recorded at time of loan closing.
All ARMs have a set time period before adjustment.
ARM adjustment periods "vary with the selected ARM program. ARM loans amortize (payoff) in the same manner as a fixed rate loan. The only difference between a fixed rate and ARM loan is that the ARM interest rate changes periodically over the life of the loan.
The ARM adjustment period can be for 1, 3, 6 or 12 months.
Sub-Prime lenders will fix the interest rate for 18, 24 or 36 months and then convert to a 6 or 12 month ARM.
Many lenders are offering hybrid ARMs that have a fixed rate for 3, 5, 7 or 10 year periods before converting to a 6 or 12 month ARM.
Many lenders offer a fixed rate interest only ARM hybrid.
All ARMS, except the POARM, have adjustment caps.
Traditional semi-annual ARMs have a of plus or minus 1.0% adjustment cap, whereas the 12 month ARM will have a plus or minus 2.0% adjustment cap. These adjustment caps can vary with selected ARM loan program.
The lender ARM disclosure notice will outline the ARM program.
Read all disclosures carefully.
Sub-Prime ARM lenders use 1.5% semi-annual caps and a 3.0% annual caps.
The ARM Fully Indexed Rate (FIR) formula computes the indicated ARM interest rate at time of adjustment. The interest rate adjustment cap will limit the increase or decrease of the existing interest rate to the cap percentage.
As an example, if the current semi-annual interest rate is 6.0%. At the end of the 6 month fixed period, the maximum rate increase or decrease is limited to 1.0%. The interest rate for the next 6 months can not be less than 5.0% or greater than 7.0%.
A 2% annual cap would range from 4 to 8%.
If the FIR is somewhere in between the 5 and 7% , then the FIR sets the interest rate for the next 6 months: FIR = 6.125% and is between the 5.0% and 7.0% limits, therefore the rate is 6.125% for next 6 months.
If the FIR = 7.5%, the maximum rate for the next 6 months is controlled by the ARM 1% adjustment cap which limits the rate increase to 7.0%.
ARM loans will have a life cap of 5, 6 or 7% above the initial start rate i.e.
initial rate is 5.500%, then the life cap would be either 10.5, 11.5 or 12.5%.
Life caps are important in a volatile market.
Investors prefer ARM loans as a hedge against inflation. In volatile economic times, the ARM payments will rise and can be a risk to the investor.
ARM loans are a two headed investment that play out well in a stable economy, but can be a looser in an inflationary environment.
As ARM borrower payments rise and incomes stagnate or evaporate because of job loss, default become a reality.
Investor losses offset the expected inflationary hedge. Every body looses.
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