The majority of borrowers these days are opting for what is known as a fixed period ARM or adjustable rate mortgage.  Traditionally a home buyer would live in a property for 20 to 30 years and getting a 30 year fixed mortgage made a lot of sense.  These days the average borrower, particulary in California does not hold onto a property for more than five years, so many borrowers are opting for a loan to meet that time frame.  Many of my clients are opting for either a 5 year or 7 year ARM, depending on how long they believe they will be in the property.

How does an ARM work?

Let's say you are like the majority of my clients and you opt for a 5 year fixed.  For a loan amount of say $500,000 the rate is 5% and you will have Principal & Interest (this can be an interest only loan as well)

(500 x 5.37) = $2,685 (Principal & Interest)

(from amortization table)

So for the next 5 years your payment will be $2,685 no matter what the interest rates are, this payment is fixed.

What happens after my fixed period is up?

All ARM's have what is called a Margin and all ARM's are tied to what is called an Index.

The average Margin that many lenders use is 2.75%.  However, it can be lower or higher.  Think of the Margin as a base or a foundation for what your future interest rate will be determined.  The margin never changes!

To come up with your future rate, the lender will add the Margin to a particular Index, it can be the Treasury, Cost of Funds Index, LIBOR, or any other index.

As I said the Margin never changes, the Index does.  The Index changes on a daily basis.

So let's assume that our Margin is 2.75% and we are tied to a particular Index such as the 1 year CMT which is at 3.2%.  Our new rate for the 6th year of the loan:

2.75% + 3.2% = 5.95% 

Since there are 25 years left on our original loan, remember 5 years have gone by, we will amortize the balance of the loan on a 25 year schedule:

(463 x 6.45)  = $2,975 (Principal & Interest)

So not only has the Interest rate gone up causing the payment to go higher but we are amortizing the loan over a shorter period, 25 years verses 30 years which also causes the payment to increase!

What are CAPS?

CAPs protect you from having a huge change in initial interest rate.  So let's go back to our original 5% loan which we took out.  Many lenders will have CAPS that look something like this: 3/2/5  - the 3 is the 1st adjustment, the 2 is every subsequent adjustment, and the 5 is for the life time.

So breaking this down, on year six, your rate cannot go higher or lower by more than 3% from the starting rate.  So if our initial rate was 5%, on the 1st adjustment it cannot go higher than 8%.

Every year there after, the rate cannot go higher or lower by 2%.  So, a worst case scenario on year 7 would be 10%, but remember that the most the rate can go up in the lifetime is 5% from the initial start rate, which was 5% as well.  So the lifetime high would be 10%.