Adjustable Rate Home Loans (ARM)

The adjustable rate mortgage (ARM) is a home loan whose interest rate and payment are adjusted periodically throughout the life of the loan.  Though the initial interest rate is lower than traditional 30 year fixed rate mortgages (also known as a "teaser rate"), the actual interest rate is dependent upon several factors:

The index:  This is a published market rate such as the U.S. Treasury Bill, 11th District Cost of Funds Index (COFI), or the London Interbank Offering Rate (LIBOR).  

The margin:  This is a set percentage that is added to the index to calculate the current interest rate.  Margins will vary from ARM to ARM.

The caps:  Interest rate caps protect the consumer from wild shifts in interest rates changes from one payment period to another.  There are two caps that a borrower should look at: 1) the adjustment cap that limits how much the interest rate may increase or decrease between each adjustment; and 2) the lifetime cap that limits how high or how low the interest rate may be over the life of the loan. 

Though many consumers are initially wary of a mortgage whose interest rate can increase during the life of the loan, there are many situations where this type of financing is advantageous for a home owner.  First, if the borrower anticipates an increase in income in his/her future, the ARM may allow the buyer to purchase a larger home than he/she would have normally qualified to buy.  Second, ARMs allow a borrower to take advantage of declining interest rates due to the a declining index without the expense of refinance the mortgage.  Third, ARMs allow home buyers to spend less on interest costs if he/she plans on living in the home for less than five years.  Fourth, if the borrower pays additional principal each year towards the loan, the future payments are calculated upon the lower principal amount rather than the original loan amount.  In time this may translate into lower monthly payments and/or lower interest costs.

The major drawback remains the potential for a higher interest rate which results in a higher monthly payment in the future.    

The following are highlights of this loan program:

Adjustment period:  Once every 12 months the interest rate is recalculated using the margin and index.

Margin:  1 Year U.S. Treasury

Caps:  Adjustment cap of 2% and lifetime cap of 6%

Down Payment Requirements:  The minimum down payment required for this type of loan is 5% of the sales price for owner-occupied properties.  Buyers purchasing a second home are required to put a minimum of 20% down on the home.  Real estate investors and non-owner occupied buyers are not eligible for this type of loan.  Down payment requirements will vary with the number of units and the reason for the loan (i.e. purchase, rate and term refinance or cash-out refinance).

Income and employment:  There are no limitations placed upon income requirements. As for employment, there are no limitations on a specific length of time at a particular job. However, a 2 year history is required, preferably in the same line of work (education can be counted towards this 2 year history if it is for the same profession the borrower is currently in).  

Eligible properties and occupancy requirements: Single family attached and detached homes, 2 to 4 unit properties, planned urban developments (PUDs), and Freddie Mac approved condominiums.

Closing Costs:  Closing costs and prepaids may be paid by interested parties (i.e. seller) as long as they are considered in the contribution limitation.  For primary residences, the seller may contribute up to 3% of the sales price if the buyer is putting less than 10% down otherwise the seller can contribute up to 6% of the sales price.

Assumability:  Yes, with the approval of the lender.  The buyer must credit qualify to assume the existing loan.

Pre-payment Penalty:  Not applicable.

Cash Reserves:   The borrower is required to have a minimum of two months cash reserves in the bank by the close of escrow.  Proceeds from cash-out refinances are not considered reserves.  

Gift Funds:  Gifts are allowed on owner occupied and primary residence transactions only.  If the down payment is 20% or greater, 100% of the down payment may be gifted otherwise the borrower must have at least 5% of his/her own funds to contribute to the down payment.

Credit Scoring:  Generally Fannie Mae and Freddie Mac require a minimum credit score of 620 for owner occupied and second homes.  

Co-Signors (Non-Occupant Co-Borrowers):  Allowed on purchases with a minimum down payment of 25% of the sales price.

Qualifying Ratios:  Fannie Mae and Freddie Mac limit a borrower's monthly payment not to exceed 28% of their gross monthly income. A borrower's total debt (proposed monthly payment plus monthly payments towards credit cards, student loans, car payments, and other installment and revolving credit) cannot exceed 36% of their gross monthly income.  If compensating factors are present or if the borrower has an above average credit score, the stated ratios may be exceeded.