Variable-rate Mortgage - ARM Variants - Cash Flow ARMs

Cash Flow ARMs

A cash flow ARM is a minimum payment option mortgage loan. This is a fancy term for a loan that allows a borrower to choose their monthly payment from several options. These payment options usually include the option to pay at the 30-year level, 15-year level, interest only level, and a minimum payment level. The minimum payment level is usually lower than the interest only payment. This type of loan can result in negative amortization. The option to make a minimum payment is usually available only for the first several years of the loan.

Cash flow ARM mortgages are synonymous with option ARM or payment option ARM mortgages, however it should be noted that not all loans with cash flow options are adjustable. In fact, fixed rate cash flow option loans retain the same cash flow options as cash flow ARMs and option ARMs, but remain fixed for up to 30 years.

Terminology
Term Definition
X/Y Hybrid ARMs are often referred to in this format, where X is the number of years during which the initial interest rate applies prior to first adjustment (common terms are 3, 5, 7, and 10 years), and Y is the interval between adjustments (common terms are 1 for one year and 6 for six months). As an example, a 5/1 ARM means that the initial interest rate applies for five years (or 60 months, in terms of payments), after which the interest rate is adjusted annually. (Adjustments for escrow accounts, however, do not follow the 5/1 schedule; these are done annually.)
Fully Indexed Rate The price of the ARM as calculated by adding Index + Margin = Fully Indexed Rate. This is the interest rate your loan would be at without a Start Rate (the introductory special rate for the initial fixed period). This means the loan would be higher if adjusting, typically, 1–3% higher than the fixed rate. Calculating this is important for ARM buyers, since it helps predict the future interest rate of the loan.
Margin For ARMs where the index is applied to the interest rate of the note on an "index plus margin" basis, the margin is the difference between the note rate and the index on which the note rate is based expressed in percentage terms. This is not to be confused with profit margin. The lower the margin the better the loan is to the borrower as the maximum rate will increase less at each adjustment. Margins will vary between 2% and 7%.
Index A published financial index such as LIBOR used to periodically adjust the interest rate of the ARM.
Start Rate The introductory rate provided to purchasers of ARM loans for the initial fixed interest period.
Period The length of time between interest rate adjustments. In times of falling interest rates, a shorter period benefits the borrower. On the other hand, in times of rising interest rates, a shorter period benefits the lender.
Floor A clause that sets the minimum rate for the interest rate of an ARM loan. Loans may come with a Start Rate = Floor feature, but this is primarily for Non-Conforming (aka Sub-Prime or Program Lending) loan products. This prevents an ARM loan from ever adjusting lower than the Start Rate. An "A Paper" loan typically has either no Floor or 2% below start.
Payment Shock Industry term to describe the severe (unexpected or planned for by borrower) upward movement of mortgage loan interest rates and its effect on borrowers. This is the major risk of an ARM, as this can lead to severe financial hardship for the borrower.
Cap Any clause that sets a limitation on the amount or frequency of rate changes.

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