Adjustable-rate mortgage (ARMS)

1. What does 10/1,  7/1,  5/1, 5/6, 3/1, etc. mean?

5/1 ARM is a very common type of 30 year adjustable-rate mortgage. This means that the rate will adjust periodically - the first part before the slash (5/x) refers to the fixed period of the mortgage and the second part (x/1) is the time period which states how often the interest rate will adjust after that, 1 is annually. Thus, for 5/1 ARM = if you were to close your loan on 12/1/2022 the first-rate adjustment will occur 5 years later on 12/1/2027. So now, when the next adjustment will happen, the lender will recalculate the interest on your loan on however that rate changed (up or down) from the initial rate. Thus, one year later, annually, the loan will adjust again, and the process will repeat to the end of the 30-year period. The point when the initial fixed interest rate changes to an adjustable rate, that "point of time" is referred to as the reset date.  Note: If it said 5/6 ARM instead of 5/1, then the second part means that the interest rate will adjust every 6 months after the initial period. not annually.

ARMs vs fixed rate scares folks in that there is some risk exposure associated to higher rates when the fixed period portion of the ARM is up. When Interest rates for ARMs is lower vs a 30-year fixed loan by a full percentage point or higher, ARMS can be seen as desirable since monthly payments upfront are more affordable. This entices some folks to get a larger house or better location because the lower payment feels like one can take on a bigger mortgage; not to mention if interest rates fall then the monthly payment may decline when the initial period is up or during any future reset(s).

The index is a major factor in determining the rate you pay for ARMs and is called SOFR (the Secured Overnight Financing Rate.) Thus, the mortgage rate for the ARM = the rate of the index + a stated margin. For example, if SOFR was 1.05% and if the margin = 2 percentage points, the loan rate = sum of these two = 1.05+2 = 3.05%.

For the 10/1 ARM the initial rate is fixed for the first 10 years(decade) vs five years. Because it is a longer period, generally the interest rate will be a little higher than the shorter-term initial period, since the initial rate is locked in for a longer period.

For 7/1 ARM same is true except the initial rate will adjust after the first seven years vs first five years. Again, the rates on the 7/1 ARM will be higher than the 3/1 and/or 5/1 because it reflects the longer fixed period. If folks know that they want to move or refinance within seven years, then choose 7/1 option.

Please note 2 things: the rate resets every year after the initial fixed period based on the index and margin, and ARMs have a cap on how much the interest rate can rise over the life of the mortgage or during the annual reset. There is definitely more complexity associated with so many more moving parts in an adjustable mortgage vs fixed, such as rate caps, indexes, resets. Choosing "interest payments only" and NOT principal in the initial period PLUS in this scenario if the home values drop, that would be very risky.