A 1 year ARM is a loan with a fixed rate for the first year that has a rate that changes yearly for the remaining life of the loan. Because the interest rate can change after the first year, the monthly payment may also change.
A 1 year ARM is a form of Adjustable Rate Mortgage (ARM). A 1 year ARM generally offers a low initial interest rate, but it carries with it the risk of higher interest rates in the future.
A 1 year ARM generally has a lower initial interest rate than a fixed mortgage, but it only keeps this initial rate for the first year. Once that year is over, the interest rate of a 1 year ARM can go up or down each subsequent year over the term of the loan. You run the risk that interest rates can go up dramatically, causing your mortgage payment to sharply increase. The interest rate can change, or adjust, based on an index. An index is a published interest rate based on the returns of investments such as U.S. Treasury securities. The rates for these investments change in response to market conditions, so an index tends to track to changes in U.S. or world interest rates. This means that the interest rate on a 1 year ARM can be adjusted up or down depending on current interest rate conditions.
A 1 year ARM does have a rate adjustment cap that limits the size of the initial rate adjustment and another cap that limits the size of subsequent rate adjustments. Caps refer to a legally required maximum on how much the interest rate of an ARM can increase over the life of the loan. The overall cap limits the interest rate for the entire life of the loan. The periodic cap limits how much the interest rate can increase at each adjustment period. This protects you from unreasonable rate increases after one year.
For example, say the index rate rises from 2.5 percent to 5.5 percent during an adjustment period. That would make an ARM interest rate of 4.5 percent rise to 7.5 percent. With a 2 percent cap, however, the interest rate on the ARM could only adjust to 6.5 percent.
A 1 year ARM can be appealing due to its low initial interest rate. The initial lower interest rate causes your monthly mortgage payment to be lower at first. However, you do need to carefully consider the consequences when deciding whether or not to get a 1 year ARM. If interest rates are expected to drop for the foreseeable future, an ARM becomes more appealing. If interest rates are expected to rise, an ARM becomes more costly.
When deciding whether or not to get a 1 year ARM, calculate the highest payment that you can afford without putting too much financial stress on yourself. Figure out how high interest rates will have to go to reach that point. If interest rates are likely to go that high, maybe an ARM is not for you. If, however, you have some wiggle room and/or the chance to sell or refinance before that point, a 1 year ARM may be a good option to consider.