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What is a adjustable rate mortgage

what is a adjustable rate mortgage

Adjustable Rate Mortgage (ARM)

Shopping and comparing Adjustable Rate Mortgages, or an "ARM" mortgage as they are sometimes called is not as easy as shopping for a fixed rate loan. ARM loans have interest rates (and monthly payments) that are subject to increase.

To compare one ARM with another or with a fixed-rate mortgage, you need to know about indexes, margins, discounts, caps, negative amortization, prepayment penalties and convertibility. You need to consider the maximum amount your monthly payment could increase and to understand how and why the payment could increase.

Federal Law requires all lenders to provide you with a full written disclosure that explains exactly how their ARM loan works and historical data about interest rate adjustments. Before you apply for an ARM loan, ask the lender to provide you with a copy of their ARM Loan Disclosure.

What is an ARM?

With a fixed-rate mortgage, the interest rate stays the same during the life of the loan. But with an ARM, the interest rate changes periodically, usually in relation to an index, and payments will go up or down accordingly.

Lenders generally charge lower initial interest rates for ARMs than for fixed-rate mortgages. This makes the ARM easier on your pocketbook at first than a fixed-rate mortgage for the same amount. It also means that you might qualify for a larger loan because lenders sometimes make this decision on the basis of your current income and the first year's payments. Moreover, your ARM could be less expensive over a long period than a fixed-rate mortgage -for example, if interest rates remain steady or decrease.

Against these advantages, you have to weigh the risk that an increase in interest rates would lead to higher monthly payments in the future. It's a trade-off-you get a lower rate with an ARM in exchange for assuming more risk.

We certainly don't mean to scare you away from ARM loans. For many people in a variety of situations, an ARM is the right mortgage choice, particularly if you income is likely to increase in the future or if you don't plan on being in the home for more than 3 to 5 years.

How ARMs Work

The Adjustment Period

With most ARMs, the interest rate and monthly payment change every year, every three years, or every five years. However, some ARMs have more frequent interest and payment changes. The period between one rate change and the next is called the adjustment period. So, a loan with an adjustment period of one year is called a one-year ARM, and the interest rate can change once every year. Many ARMs offer an initial adjustment that is longer than the future adjustments. For example, a common ARM type is a 3-year ARM. The interest rate will not change for the first 3 years (the initial adjustment period) but can change every year after the first 3 years.

The Index

Most lenders tie ARM interest rate changes to changes in an index rate. These indexes usually go up and down with the general movement of interest rates. If the index rate moves up so does your mortgage rate in most circumstances, and you will probably have to make a higher monthly payment. On the other hand, if the index rate goes down your monthly payment may decrease.

Lenders base ARM rates on a variety of indexes. Among the most common are Treasury Securities, Treasury Bills, LIBOR, or COFI. You should ask the lender what index will be used and how often it changes. Also, ask how it has behaved in the past so that you can compare it to other indexes. Ask where it is published so that you can find the current value whenever you'd like.

The Margin

To determine the interest rate on an ARM, lenders add to the index rate a few percentage points called the "margin". The amount of the margin can differ from one lender to another, but it is usually constant over the life of the loan. Ask any lender you are considering what the margin is that will be added to the index when calculating your interest rate in the future. Comparing one lender's margin to another's is more important than comparing the initial interest rate, since it will be used to calculate the interest rate you will pay in the future.

Initial Rate Mortgage

Many lenders offer a lower than market initial rate for their ARM loans. You should be careful to consider whether you will be able to afford payments in later years when the discount expires and the rate is adjusted.

Here is how a discount might work. Let's assume the one-year ARM rate (index rate plus margin) is at 8%. But your lender is offering a 6% rate for the first year. This means that even if market conditions stay

the same, your interest rate will increase at the first adjustments to 8%. Compare the current index rate plus margin to the initial rate the lender is offering so that your will be prepared for the payment increase that is likely to occur.

You can protect yourself from big increases by looking for a mortgage with features, described next, which may reduce this risk.

Reducing Risk

Most ARMs have caps that protect borrowers from extreme increases in monthly payments. Others allow borrowers to convert an ARM to a fixed-rate mortgage. While these may offer real benefits; they may also cost more, or add special features, such as negative amortization.

Interest-Rate Caps

An interest-rate cap places a limit on the amount your interest rate can increase or decrease. There are two types of caps:

  1. Periodic or adjustments caps, which limit the interest rate increase from one adjustment period to the next.
  2. Overall or lifetime caps, which limit the interest rate increase over the life of the loan.
By law, virtually all ARMs must have lifetime caps. As you can imagine, interest rate caps are very important since no one knows what can happen in the future.

Negative Amortization

Though not as popular as it once was, some ARM loans have a payment cap in addition to an interest rate cap. This means that even though a future interest rate would be established by adding the margin to the index rate, the amount that the monthly payment can increase would be limited as well. Because payment caps limit only the amount of payment increases, and not interest rate increases, payments sometimes do not cover all of the interest due on your loan. This means that the interest shortage in your payment is automatically added to your debt, and more interest may be charged on that interest. You might therefore owe the lender more later in the loan term than you did at the start. This is called negative amortization.

Some mortgages contain a cap on negative amortization. The cap typically limits the total amount you can owe to 125% of the original loan amount. When the point is reached, your monthly payments may be set to fully repay the loan over the remaining term and you payment cap may not apply. You may limit negative amortization by voluntarily increasing your monthly payment.

Negative amortization can put you in a very leveraged position and may make it difficult to sell your home in the future, particularly if you have made a small downpayment and the loan balance increases faster than home values in your area. Be sure to ask you lender whether negative amortization can occur before deciding which ARM loan is best for you.

Prepayment Penalties

Some lenders may require you to pay special fees or penalties if you pay off the ARM early. Many ARMs allow you to pay the loan in full or in part without penalty whenever the rate is adjusted. Make sure you know if the loan you are considering contains a prepayment penalty.


Your agreement with the lender can have a clause that lets you convert the ARM to a fixed-rate mortgage at designated times. When you convert, the new rate is generally set at the current market rate for fixed-rate mortgages. The interest rate or up-front fees may be somewhat higher for a convertible ARM. Also, a convertible ARM may require a special fee at the time of conversion. Details about it and how you could convert your ARM to a fixed-rate loan can be found in the ARM Program Disclosure provided by your lender.

Additional Information

Before you actually apply for a loan and pay a fee, ask for all the information the lender has on the loan you are considering. It is important that you understand index rates, margins, caps, and other ARM features like negative amortization. You can get helpful information from lender provided disclosures, which are subject to certain federal standards.

Federal law requires the lender to give you information about adjustable-rate mortgages. Ask the lender for a copy of their ARM Program Disclosure before applying for the loan.

Selecting a mortgage may be the most important financial decision you will make and you are entitled to all the information you need to make the right decision. Don't hesitate to ask questions about the ARM features when you talk to lenders, real estate brokers, sellers and your attorney, and keep asking until you get clear and complete answers.

Review information about ARM's on the lender's web site, if available, before making a final decision. If you can't find the information you are looking for on the web site call or email them to get the answers you need. Ask questions before committing yourself!

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