ARMs Served Up in a Variety of Forms

If you’re in the market for a mortgage, you know that most fixed-rate loans are fairly straightforward. You shop for a rate, negotiate fees and costs, and decide whether to opt for a 15-year or a 30-year loan.

Adjustable-rate mortgages, on the other hand, come in a stunning array of choices. When they adjust, how they adjust, how much they can adjust and how much you ultimately owe on the loan can differ widely.

ARM borrowers get a discount on the initial interest rate in exchange for taking the risk that their loan payments will fluctuate. The initial or “teaser” rate may last from one to 12 months for a traditional ARM, or up to 10 years for so-called hybrid ARMs, which combine an initial fixed rate that expires after three to 10 years before becoming a loan that adjusts annually.

The most popular adjustable mortgage is the one-year ARM with payments that change once a year, based on a common interest rate benchmark.

Some of the most frequently used benchmarks are the one-year or six-month U.S. Treasury bill rate; a bank certificate of deposit index; the LIBOR (which stands for London InterBank Offer Rate, the rate paid on dollar-denominated deposits traded among global banks); and the COFI (Cost of Funds Index, which is based on average interest expenses of savings institutions).

COFI-based ARMs are generally considered the least volatile.

The LIBOR and the one-year Treasury are also popular choices for their relative stability.

Most lenders base their ARM payment adjustment on the loan’s benchmark rate 45 days before the anniversary date of the loan. Rates on loans that will adjust this month, for example, typically will be based on benchmark levels of mid-April.

Most ARMs are structured so that lenders add 2 to 3 percentage points to the benchmark to determine how much the borrower pays after the initial teaser rate expires.

Most ARMs also have caps that limit how much the interest rate or the payment can rise in a single year. A typical annual interest rate cap is 2 percentage points.

All loans also have lifetime caps that limit the maximum amount of interest that can be charged; a typical lifetime cap is 6 percentage points over the initial rate.

Hybrid ARMs, however, often do not apply the smaller annual cap in the first year that the loan adjusts. In other words, a three-year hybrid ARM’s loan rate can leap up to 6 percentage points after the initial three-year fixed period expires.

Some ARMs with annual payment caps carry the risk of “negative amortization”--that is, the payment will be lower than the actual interest owed, which can extend the length of the loan, since the unpaid interest is added on to the outstanding balance.

In that case, lenders give borrowers the option of making the capped payment or a larger “fully amortized” payment to avoid negative amortization.

With all ARMs, prepayment penalties are common and can wipe out the benefit of a low teaser rate if you refinance or move before the penalties expire.