What is a Fixed-Period ARM
A fixed-period ARM is an adjustable-rate mortgage with an initial fixed-interest-rate period. After the fixed-interest rate expires, the interest rate starts to adjust based on an index plus a margin. The amount by which the interest rate can adjust after the fixed period is usually subject to an interest rate cap structure.
BREAKING DOWN Fixed-Period ARM
The prime mortgage market typically offers fixed-period ARMs, also known as hybrid ARMs, with fixed-interest rate periods of three, five, seven and 10 years. These are advertised as 3/1, 5/1, 7/1 and 10/1 ARMs. In the subprime market, a two-year fixed-rate period is frequently offered. Typically, the shorter the fixed-interest rate period, the lower the interest rate will be. A borrower should carefully consider their time horizon when choosing a fixed-period ARM and recognize the risks associated with the expiration of the fixed-interest rate period.
Once the fixed rate period expires, the rate adjustments a borrower may face in a fixed-period ARM are governed by the mortgage’s interest rate cap. These provisions can protect borrowers in periods of rising interest rates. Borrowers should also be aware of their mortgage’s initial interest rate cap, which is the maximum amount the interest rate on an ARM can increase on its first adjustment.
Benefits and Limitations of Fixed-Period ARMs
Compared to traditional fixed-rate mortgages, fixed-period ARMs will typically feature lower rates on payments until the fixed period expires. Borrowers may be able to use these lower payments to qualify for larger homes than they otherwise could. For borrowers who don’t plan to live in one place for more than a few years, ARMs also provide a more affordable way to buy a home. And in periods of declining interest rates, ARM borrowers are not forced to pay the extra costs of refinancing to earn a lower rate as these loans (and monthly mortgage payments) adjust periodically.
Volatile interest rates and housing prices pose the greatest risks for holders of ARMs loans. Once the fixed-period ends and depending on the remaining length of the loan, rates and monthly payments can rise significantly. If the fixed-period ARM is an interest-only or negatively amortizing loan, meaning the borrower pays only the interest on the loan or even less for the fixed period, they will face a much higher payment when it adjusts that includes principal and interest. In a period of falling home prices, holders of these type of loan could owe more than their home is worth. To manage these risks, depending on credit and housing market conditions, borrowers may have the option to refinance their loan or sell their home to pay off the loan,