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Definition: Fixed Period ARM
ARM is Adjustable rate Mortgage. This type of mortgage loan starts initially with a fixed rate of interest for a specified period after which it adjusts based on an index plus a margin. The interest rate cap structure determines the amount by which the interest rate adjust after the fixed period. In a fixed period ARM the fixed rate of interest is offered for a period of three or five or 10 years. The shorter the period the lower the interest rate charged. The person who takes this type of loan should be aware of the time horizon and also the risks that this loan entails after the expiration of the fixed period.
The advantage of this type of loans is that the interest rate charged is lower than a 30 year period fixed rate of interest loans. These type of interest are linked to treasury securities index of one year. After the fixed period your interest rate changes and so does the payments made monthly. Initial rate of interest for ARM’s is lower than fixed rate.
E.g. If you buy a house and don’t plan on staying there for a long term then ARM’s are suitable for you because you plan to move or sell when the fixed period interest expires. If you think your income will increase in the future then you might be comfortable with making lower payments now and save for future and make higher payments when the rate of interest increases.
ARMs are usually risky because it is highly likely that the rate of interest will increase in the future. Hybrid ARM’s are what led to the mortgage crisis in 2008. You can determine by how much the rate of interest will increase or decrease after the fixed period based on the index it is tied to and the margins. The index is variable Willke the margin remains constant. Generally the interest rates are tied to LIBOR, T-Bill or COFI (cost of funds index). Usually ARMs have an initial cap that is the maximum allowable rate of interest that can be adjusted after the fixed period expires. Periodic Cap is the limit to which the interest rate can increase from one period to another. Lifetime or overall cap is the maximum interest rate that can be charged over the lifetime of the loan.
E.g. for a 5 year 2/2/5 cap structure of the loan means the format of initial cap/periodic cap/Lifetime cap
if you take a $400,000 loan for 5/2/5 for a 4% rate of interest will be
Principal and Interest paid
1-5 (initial loan)
$266.66 per month
6 (resets 2% increase)
$1920 per month
7 (resets 2% increase)
$2406.4 per month
8 (increases only 1 % more because the lifetime cap is 5%)