Reader question: “I understand the basics of how an adjustable-rate mortgage loan works. I’m just wondering how many different kinds there are these days. I read somewhere that a lot of the ARM products used during the ‘boom’ years are no longer being offered by lenders. How many different types of adjustable-rate mortgages are there these days?”
Most of the ARM loans available today are actually “hybrid” loans. As you probably know, a hybrid is a combination of two different things, like a hybrid engine that is powered by both gas and electricity. These types of adjustable-rate mortgages start off with a fixed interest rate for a certain period of time, ranging from one to seven years in most cases. After that initial period, the rate will begin to adjust at a predetermined interval (usually annually).
The Different Types of Adjustable-Rate Mortgages
Mortgage lenders can structure ARM loans however they want, as long as they meet federal lending laws. As a result, there are many different types of adjustable-rate mortgages in use today.
In the case of a hybrid loan (defined above), the primary difference is the length of the initial fixed-rate period. During this initial period, the interest rate does not change. This stage might be anywhere from one to ten years, depending on the product. Regardless of these differences, the adjustments typically occur once every year after the initial phase has expired.
This will make more sense if we plug in some numbers. Here are some of the different types of adjustable-rate mortgage loans available these days:
- 7/1 ARM: This loan has a fixed interest rate for the first 7 years, and then adjusts annually after that.
- 5/1 ARM: Another hybrid loan structure. It holds a fixed rate for the first 5 years, and then adjusts annually.
- 1-year ARM: Fixed for the first year, annual rate adjustments after that.
So that’s how these products are different from one another. Let’s talk about what they have in common…
What All ARM Loans Have in Common
As you can see, there are several types of adjustable-rate loans to choose from. But despite their differences, they all have certain features in common. Here are some of the common threads.
Index: ARM loans are “tied” to a certain index. The index determines how the interest rate behaves after the initial phase has expired (i.e., whether it rises or falls from one adjustment to the next). For instance, many adjustable products are connected to the 11th District Cost of Funds Index (COFI) or the London Interbank Offered Rate (LIBOR).
Margin: When you take on an ARM loan, the lender will “mark up” the rate by adding percentage points to the index mentioned above. This determines what rate you will pay over the term of the loan. The margin should be disclosed to you up front.
Caps: Regardless of what type of adjustable mortgage you use, there’s a possibility that the rate may rise once the adjustments start to occur. But there are limits to how much it can rise, and these limits are known as “caps.” Lifetime caps limit how much the rate can rise over the full term of the loan. Adjustment caps limit the amount by which the rate can increase from one adjustment period to the next. These limits should also be disclosed to you up front, when you apply for the loan.
Certain Products Are No Longer Available
As you mentioned in your question, certain types of adjustable-rate mortgage products that were used in the past are no longer available today. This is the result of new federal lending laws, as well as more conservative lending practices.
The payment option ARM is a good example. This was a high-risk loan where borrowers could basically choose how much they wanted to pay each month. In many cases, the borrower would choose to pay less than the full amount due (in principal + interest), leading to a negative-amortization scenario where the loan balance actually grew over time.
This type of adjustable-rate mortgage is nearly extinct today. The Qualified Mortgage (QM) rule, which took effect in January 2014, prohibits these types of ARM products.
FHA vs. Conventional
Another distinction with ARM loans is whether you want to use conventional or FHA. The conventional type of adjustable mortgage is one that is not insured by the government. An FHA loan, on the other hand, is insured by the government through the Federal Housing Administration (part of HUD). This insurance protects the lender in the event that the borrower fails to repay the debt.
FHA loans are available in both fixed and adjustable forms. According to the HUD website: “FHA offers a standard 1-year ARM and four ‘hybrid’ ARM products. Hybrid ARMs offer an initial interest rate that is constant for the first 3-, 5-, 7-, or 10 years.”