With the move higher in mortgage rates in March and April, Orion’s AEs and our brokers are seeing renewed interest in adjustable-rate mortgages, or ARMs. As long as ARMs meet “Ability to Repay” (ATR) requirements, they are perfectly fine and agreat option for many borrowers. With that in mind, Orion figured it was a good time to review the basics, especially for new employees of brokers.

Most ARMsare “intermediate” adjustable mortgages that are fixed for a certain period of time and then adjust after that. For example, a 5/1 ARM has a fixed interest rate for the first five years and then switches to an adjustable interest ratefor the remainder of its term. Likewise, a 3/1 ARM is fixed for three years, a7/1 is fixed for seven. An ARM has a fixed rate for the first several years of the loan term that’s often called the “teaser rate” because it’s lower than any comparable rate you can get for a fixed-rate mortgage. Rates may be fixed for 7 or 10 years, although the 5-year ARM is a very common option.

Once the fixed-rate portion of the term is over, the ARM adjusts up or down based oncurrent market rates, subject to caps governing how much the rate can go up in any particular adjustment. Typically, the adjustment happens once per year and the new rate is calculated by adding an index number to a margin specified in your mortgage documentation. Common indexes used for ARMs, once they adjust, include the Secured Overnight Financing Rate (SOFR), the Cost of Funds Index (COFI) and the Constant Maturity Treasuries (CMT). And each time your client’s interest rate changes, the payment is recalculated so that your client’s loan is paid off by the end of the term.

An ARM may have “5/2/5 caps.” What does that mean? A 7/1 ARM with a 5/2/5 cap structure means that for the first seven years the rate is unchanged, but on the eighth year your client’s rate can increase by a maximum of 5 percentage points (thefirst "5") above the initial interest rate. Every year there after, the rate can adjust a maximum of 2 percentage points (the second number,"2"), but your client’s interest rate can never increase more than 5 percentage points (the last number, "5") over the life of the loan. Other than the margin in the loan documentation, there’s no limiting factor to how much the interest rate could adjust down in any particular year if interest rates have moved lower.

Because the interest rate can change in the future, an ARM is structured so that yourclient can get a lower interest rate for the first several years of the loan than they would if the client were to go with a comparable fixed rate. If your client knows that they’re in a starter home and will be moving in a few years, they might move before the interest rate ever adjusts.

This product is a great way for brokers to add value to your clients. Explaining the prosand cons are a real plus for brokers to prove their subject matter expertise!

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