Intermediate Adjustable Rate Mortgage
In actuality, the Intermediate ARM is a hybrid of the best features of a fixed rate loan and an adjustable rate loan. While the fixed rate loan gives us the security of a non-changing interest rate, the ARM gives us the advantage of a lower than market “teaser” rate. The blending of the two essentially gives a borrower a fixed interest rate for a specified period of time that is below the benchmark 30 year fixed interest rate.
Generally speaking, Intermediate ARMs have fixed rate terms of 3, 5, 7 & 10 years. Typically, the shorter the fixed rate term, the lower the fixed interest rate. Theoretically this is a function of the interest rate market being able to forecast expected interest rates over a three year period better than over a ten year period, hence, the lower rate/shorter term relationship. (For more information on this relationship, visit our “Frequently Asked Questions” section of our website … see “What is a yield curve?”)
Initially, these loans were written for a term which was equal to the fixed rate term, i.e., at the end of the term, be it 3, 5, 7 or 10 years, the borrower had to pay off the loan. This payment was frequently referred to as a balloon payment. This was a bit unnerving to borrowers who feared that circumstances could prevail when a balloon payment was due that would eliminate the ability to refinance their loan, thereby subjecting them to a potential lender foreclosure. What resulted from this very valid borrower concern was a loan product that extended the term of the loan at the end of the fixed rate period.
Currently, Intermediate ARMs are referred to as 3/1, 5/1, 7/1 & 10/1 loans. The common characteristics of these loans are: each has a fixed rate for a specific period of time; each has a term of thirty years; and, at the end of the fixed rate term, each adjusts to an adjustable rate mortgage for the remainder of the thirty year term. In other words, a 3/1 ARM would have a fixed rate for three years and an adjustable rate for 27 years, a 5/1 would have a fixed rate for five years and an adjustable rate for 25 years, and so on.
Like Adjustable Rate Mortgages, the Intermediate ARMs have caps to minimize the borrower’s interest rate exposure during periods of escalating interest rates. However, there is one important difference. Whereas Adjustable Rate Mortgages have a cap format of 2/6 (explained in our section on ADJUSTABLE RATE MORTGAGES), Intermediate ARMs have a cap that is communicated to the borrower in the following format: 6/2/6. The difference is that the first adjustment could be as high as 6.00% over the initial term interest rate. After the first adjustment, the cap acts exactly like the aforementioned Adjustable Rate Mortgage cap.