Articles & Tips
What happens when my ARM Loan Resets?
If your home mortgage loan is an adjustable rate mortgage (often abbreviated to ARM), you have lots of company. ARMs have been popular with both home buyers and refinancing homeowners for many years, since an ARM loan can increase a borrower's maximum loan amount. In addition, the initial interest rate on an ARM loan is usually much lower than the interest rate associated with fixed rate loans and other types of mortgage loan products. This low interest rate translates into lower monthly payments for at least the first six months to a year of the loan.
After the initial period ends, by definition, the ARM can reset to a different interest rate. Theoretically, if market interest rates are completely stable, the interest rate and therefore monthly payment of an ARM loan could be unchanged from one period to the next, but this is highly unlikely due to interest rate volatility.
An ARM loan's interest rate is tied to a specific well-known market interest indicator, such as the Constant Maturity Treasury (CMT), the 11th District Cost of Funds (COFI), or the London Inter Bank Offering Rates (LIBOR). In actuality, there are well over a dozen different interest rate indicators that ARM loans use to calculate their interest rate at a given point in time.
When it comes time for your ARM loan to reset, your lender will look up the interest rate for the index that your ARM uses and add in a margin amount. This margin can be different from loan to loan but is usually a few percentage points. The sum is the new interest rate for your ARM loan for the duration of the current period, until the next time your ARM loan resets.
When market interest rates are low, borrowers who hold ARM loans are usually very content, but when interest rates begin to rise, these borrowers can experience something known as ARM reset shock. This occurs when an ARM loan resets to a significantly higher interest rate than in the previous period, especially when it occurs for several periods in a row. In just a few years, a borrower could be experiencing a monthly loan payment that is many hundreds of dollars more than the original monthly loan payment.
To avoid or minimize ARM reset shock, it's always an excellent idea to look ahead and forecast the worst case scenario. Track the interest index that your ARM uses and be aware of sharp upticks; this way, you won't be caught unaware when your ARM loan resets to a higher interest rate.
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