What is a 10/1 ARM loan and how does it work? Is it risky or savvy to get a 10/1 ARM? We’ll cover the basics of how these so-called hybrid mortgage loans work and who should or shouldn’t get one.
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What is an ARM Loan?
The acronym ARM stands for adjustable-rate mortgage. An adjustable-rate mortgage is a type of home loan where the interest rate potentially changes over time based on an interest rate index.
The 1-Year Constant Maturity Treasury (CMT) index is commonly used for many adjustable-rate mortgages today.
The London Interbank Offered Rate (LIBOR) was used in the past, but it has since been phased out.
The interest rate for an adjustable-rate mortgage is calculated by adding a margin set by the lender to the index. For example, if the index equals 3.00% and the margin equals 3.00%, the fully-indexed interest rate will add up to 6.00%.
Interest rates for adjustable-rate mortgages can increase and decrease over the life of the loan depending on changes in the index. This means your monthly payment could both increase and decrease over time as well.
Though the index changes over time, the margin is set by the lender at loan closing and will never change during the loan term.
The most common adjustment frequencies are once per year or every six months.
What is a 10/1 ARM Loan?
A 10/1 ARM mortgage is a type of 30-year adjustable-rate mortgage that offers a fixed interest rate for the first ten years of the loan term. Once the first ten years have passed, the interest rate and monthly payment are adjusted annually based on the index for the remaining 20 years of the loan term.
The “10” in “10/1” ARM specifies that the interest rate is fixed for the first ten years of the loan. The “1” specifies that the interest rate adjusts once per year after the initial fixed-rate period ends.
You may occasionally run across the 10/6 ARM, which also has a fixed interest rate for the first ten years of the loan. However, once the fixed period ends, the interest rate adjusts every six months for the remainder of the loan term.
Because the 10/1 ARM mortgage has both a fixed and variable interest rate during the loan term, it’s commonly referred to as a hybrid mortgage.
When it comes to adjustable-rate mortgages, the shorter the fixed-rate period, the lower the initial interest rate. In other words, a 7/1 ARM typically has a lower starting interest rate than a 10/1 ARM, which typically has a lower starting interest rate than a 30-year fixed. The longer the fixed-rate period, the higher the fixed rate you’ll pay on the mortgage.
10/1 ARM Mortgage Rate Caps
Though the interest rate on a 10/1 ARM can change during the last 20 years of the loan, it can’t go crazy. A 10/1 ARM comes with built-in limits on the rate adjustments called caps. This provides a measure of protection and stability so your monthly payment can’t go nuts even if the index skyrockets.
The initial adjustment cap limits how much the rate can increase at the end of the 10-year fixed-rate period. For example, if the initial adjustment cap is 2%, the interest rate on the loan cannot increase more than 2% above the starting interest rate – even if the index has increased more than that.
There is a cap on subsequent rate adjustments as well. This cap is called the periodic adjustment cap and it limits how much the rate can change during each adjustment period after the initial rate adjustment.
There is also a lifetime adjustment cap, which sets a maximum interest rate beyond which the rate can never increase for the entire life of the loan. No matter how much the index increases, the interest rate can never exceed the lifetime adjustment cap.
Interest rate caps are often represented using a shorthand notation such 5/2/5 or 2/2/5. The first number represents the initial adjustment cap, the second number represents the periodic adjustment cap, and the last number represents the lifetime cap.
For example, let’s assume we have a 10/1 ARM mortgage with 5/2/5 rate caps and an initial interest rate of 4%.
Again, the “10/1” means the interest rate is fixed for the first ten years, then adjustable annually for the remaining 20 years of the loan term.
The “5/2/5” means the first rate adjustment (represented by the first “5”) cannot exceed 5% above the starting interest rate. In other words, using our example, the interest rate cannot exceed 9% at the first rate adjustment (which is 5% above of the starting rate of 4%).
The “2” represents the periodic rate adjustment, which means the interest rate cannot change more than 2% at each adjustment after the initial rate adjustment.
The last “5” represents the lifetime cap, which means the interest rate cannot exceed 5% above the initial interest rate regardless of how much the index increases.
It’s important to understand that the caps are simply the ceiling that limits how much the interest rate can change. Just because the rate can change, it doesn’t mean the rate will change. Depending on the movements in the index, the rate could increase a little, decrease a lot, or do absolutely nothing. It’s entirely possible that the interest rate for a 10/1 ARM will never increase enough to hit the rate caps.
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Why Get a 10/1 ARM Loan?
So, what is a 10/1 ARM best used for? A 10/1 ARM loan could be a good option if you don’t plan to live in your home for more than ten years.
Because the bank guarantees the rate only for the first ten years, the rate is often lower than what you would pay for a comparable 30-year fixed mortgage. This reduces your monthly payment and frees up cash for other things.
A 10/1 ARM is also a good option if you plan to pay your loan balance down rapidly. Again, the initial interest rate is typically lower than that of a comparable 30-year fixed mortgage, so more of your payment goes towards the principal.
If you pay down your principal rapidly, your loan balance will be substantially lower by the time the interest rate starts to adjust. Even if the rate hits the caps, the smaller loan balance will limit your payment increases.
In fact, if you’ve paid down your balance enough, your payment could actually decrease even if the interest rate increases to the maximum allowed.
The rate on a 10/1 ARM is often not that much lower than a comparable 30-year fixed loan. If you know you plan to be in the home for at least ten years and the thought of an adjustable rate concerns you, it might make sense to just go with a 30-year fixed loan even though the rate will be slightly higher. However, if you’re taking out a jumbo mortgage, even just a slightly lower rate on a 10/1 ARM could add up to significant interest savings over the life of the loan.
Who Should Avoid a 10/1 ARM Mortgage?
The 10/1 ARM loan is a good option, but it’s important to consider the potential risks as well. Unless you know your income will increase over the next ten years, it may be best to avoid a 10/1 ARM if you can barely afford the payments during the initial fixed-rate period.
Again, the payment could increase at the end of the fixed-rate period if the index increases. If the payments become unaffordable, you could be at risk of foreclosure.
We recommend opting for a 10/1 ARM only if you can comfortably manage the payments even if the rate increases to the caps.
It’s also worth nothing that 10/1 ARM interest rates are often not much lower than rates for a comparable 30-year fixed mortgage. If the idea of an adjustable rate concerns you, it might make sense to just go with a 30-year fixed loan.
Frequently Asked Questions
Is it a good idea to have a 10/1 ARM?
A 10/1 ARM is a great loan option if you don’t plan to remain in your home past ten years. A 10/1 ARM typically has a lower interest rate than a comparable 30-year fixed mortgage, which can result in significant interest savings. However, it’s important to also consider the risks. If you can barely afford your payments during initial fixed-rate period, you could be at risk of foreclosure if your payment increases in the future.
What is the difference between 10/1 and 10/6 ARM?
The difference is how frequently the rate adjusts once the initial 10-year fixed-rate period ends. For a 10/1 ARM, the rate adjusts once per year. For a 10/6 ARM, the rate adjusts every six months.
What happens at the end of a 10-year ARM mortgage?
A 10-year ARM mortgage is a fully-amortizing 30-year mortgage, which means it pays off at the end of thirty years. The interest rate is fixed for the first ten years of the loan, then adjustable for the remaining twenty years of the loan term.