An Adjustable Rate Mortgage - ARM - has its interest rate adjust over time depending on financial market conditions at the time of the ARM's adjustment date. In the beginning of an ARM, there is a period of time where the interest rate is fixed. This period is called the fixed period.
Typically, adjustable rate mortgages - ARMs - have a lower introductory rate, (or teaser rate, intro rate etc.) or start rate during their fixed period than a comparable fixed rate mortgage. In some cases the intro rate can as much as 5.0% below the current market rate of a fixed loan.
NOTE: As a general guideline, the lower the start rate the shorter the time before the loan makes its first adjustment. The start rate is usually fixed from 1 month to as long as 10 years depending on the type of ARM you get.
ARM Terms And Features
Adjustment Period - The Adjustment Period of an ARM is the time between when an ARM adjusts. For example, if you have a 1 year ARM then you will have a 1 year adjustment period. This means that your ARM can only adjust 1 time every 12 months.
Index - The index of an ARM is the financial instrument that the loan is 'tied' to, or adjusted to. The most common indices, or, indexes are the 1-Year Treasury Security, 10-Year Treasure Bill, LIBOR (London Interbank Offered Rate), Prime, 6-Month Certificate of Deposit (CD), MTA or Monthly Treasury Average, and the 11th District Cost of Funds (COFI). Each of these indices move up or down based on conditions of the financial markets.
Margin - The margin is one of the most important aspects of ARMs because it is added to the index to determine the interest rate that you pay. When the margin added to the index the resulting interest rate is known as the fully indexed rate. As an example if the current index value is 5.50% and your loan has a margin of 2.5%, then your fully indexed rate is 8.00%.
Margins on loans range from 1.0% to 5.0% depending on the index and the amount financed in relation to the property value. A general rule of thumb is the higher loan to value the higher margin you will get. You may also find some lenders adjust your margin based on your credit score - higher score means a smaller margin.
Periodic Adjustment Caps - All adjustable rate loans carry perdiodic adjustment caps. The periodic cap limits the amount your interest rate can change from one adjustment to the next. Often the interest rate is limited to be able to change 1-2% either up or down from one adjustment to another. This prevents huge changes in payments, but still allows for the interest rate to change in the direction of financial market conditions at the time of the adjustment.
Payment Caps - Some loans have payment caps instead of interest rate caps. These loans reduce payment shock in a rising interest rate market, but can also lead to deferred interest or 'negative amortization'. These loans generally cap your annual payment increases to 7.5% of the previous payment.
Lifetime Caps - Almost all ARMs have a maximum interest rate or lifetime interest rate cap. The lifetime cap varies from company to company and loan to loan. Loans with low lifetime caps usually have higher margins, and the reverse is also true. Those loans that carry low margins often have higher lifetime caps.
Hopefully you now have a better understanding of the terms associated with adjustable rate mortgages. Remember, if your loan officer is trying to offer you an ARM and you do not understand something about the ARM make sure you ask. Your home is not worth the risk of overlooking something you do not understand.
