What Is a 10/6 ARM and How Does It Work?
Unpack the mechanics of a 10/6 ARM, understanding its unique fixed and adjustable periods, rate components, and payment adjustments.
An adjustable-rate mortgage (ARM) is a home loan where the interest rate can change over time. Unlike a fixed-rate mortgage, which maintains the same interest rate, an ARM has an initial fixed-rate period, then adjusts. A 10/6 ARM defines how long the initial fixed rate lasts and how frequently it adjusts afterward.
Understanding Adjustable-Rate Mortgages
An adjustable-rate mortgage is a home loan with an interest rate that can fluctuate periodically. This differs from a fixed-rate mortgage, where the interest rate remains constant. An ARM typically begins with a fixed interest rate for a set number of years.
After this initial fixed-rate period, the interest rate on an ARM becomes variable. The rate changes at predetermined intervals, moving up or down based on market conditions. This influences the borrower’s monthly payment.
The 10-Year Fixed Period and 6-Month Adjustment
The “10” in 10/6 ARM indicates the initial interest rate is fixed for the first 10 years. During this period, the borrower’s interest rate and, consequently, their principal and interest payments remain stable and predictable. This provides a significant period of payment consistency before any adjustments occur.
After this initial 10-year fixed-rate phase, the loan transitions into its adjustable period. The “6” signifies that after the first 10 years, the interest rate adjusts every six months for the remainder of the loan term. This means that twice a year, the interest rate can change, reflecting current market conditions. Each time the rate adjusts, the borrower’s monthly mortgage payment is recalculated based on the new interest rate.
Elements of the Adjustable Rate
During the adjustable phase of a 10/6 ARM, the interest rate is determined by combining two main components: an index and a margin. The index is a market-driven interest rate that fluctuates based on economic conditions. Common indexes used for ARMs include the Secured Overnight Financing Rate (SOFR) and the Constant Maturity Treasury (CMT).
The margin is a fixed percentage amount that the lender adds to the index rate. This margin is set at the time the loan is originated and remains constant throughout the life of the mortgage. For example, if the index is 4.0% and the margin is 2.5%, the fully indexed rate would be 6.5%. The sum of the current index value and the fixed margin determines the borrower’s interest rate during each adjustment period.
Payment Adjustments and Rate Caps
When the interest rate on a 10/6 ARM adjusts every six months after the initial fixed period, the borrower’s monthly mortgage payment will also change. If the combined index and margin result in a higher interest rate, the payment will increase. Conversely, if the rate decreases, the payment will go down.
To provide some predictability and limit drastic changes, ARMs typically include interest rate caps. There are generally three types of caps: an initial adjustment cap, periodic adjustment caps, and a lifetime cap. The initial cap limits how much the interest rate can change at the very first adjustment after the fixed period ends. Periodic caps restrict how much the rate can increase or decrease in subsequent adjustment periods. A lifetime cap sets the maximum interest rate that can be charged over the entire duration of the loan. These caps are designed to protect borrowers from excessive payment volatility.