Adjustable Rate Mortgage

Adjustable Rate Mortgages, commonly referred to as ARMs, are mortgages with interest rates that can change periodically, according to the economic index selected when the mortgage is issued. The initial interest rate is lower than a fixed-rate mortgage, but the monthly payment can rise and fall along with the economy. When you choose an ARM, you exchange the possibility of lower interest rates for the risk of a possible rate increase.

There are many benefits to choosing an ARM:

1. The initial interest rate on an ARM is generally 2-3 points lower than a fixed-rate mortgage. The lower initial interest rate will allow you to qualify more easily for the house you want to buy.
2. You may qualify for a larger loan with an ARM than with a fixed rate mortgage, which means you can probably purchase a more expensive home.
3. An ARM may save you money if you plan to move within a few years and are not concerned about the long-term possibility of rate and payment increases.
4. You may consider the risks involved in an ARM if you expect your income to increase enough to cover potential increases in payments, or if you expect rates to fall.

The interest rate on an adjustable mortgage can change according to the response of a financial index to changes in the economy. A large variety of ARMs are available, each tied to a different market index, such as CDs, T- Bills, or LIBOR rates. Some indexes move slowly because they are "averages," such as the 11th District Cost of Funds. Others react to market changes more quickly, such as the six-month CD or the one-year Treasury Bill.

When your interest rate is due to be adjusted, the margin (a previously determined percentage) is added to the current rate of the index to which your loan is tied. This determines the new rate. The frequency and dates of adjustments are established when you apply for your loan. ARM interest rates and monthly payments may change monthly, every six months, once a year, or every three, five, or seven years, depending on the terms of your loan and the activities of the market.

"Caps" limit the amount by which the interest rate can increase at each adjustment, thereby protecting you from drastic changes in interest rates. There are two caps to be considered: The LIFE CAP is the maximum amount the interest rate can rise over the life of your loan--the highest it can ever go, regardless of the fluctuations in the market. If you have a typical one-year ARM, your loan may have a lifetime rate cap of 6%. If you have an initial interest rate of 4%, the highest you would ever pay would be 10%. The second cap to consider is the ANNUAL CAP, which may top out at 2%. This means your interest rate can never increase by more than 2% in any one year.

Some adjustable loans offer payment caps which limit the amount by which your monthly payment can increase. This might sound appealing, but these caps do not limit the amount by which interest can increase. Payment caps can lead to deferred interest, which is added to the unpaid balance of the loan. If interest rises by more than your payment cap requires you to pay, the additional interest not covered by your payments is added to your loan. This is called negative amortization. With a negative amortization ARM, it is actually possible for you to owe more later in the loan term than you borrowed initially. This can also occur when payments early in the term don't cover the cost of the principal and interest.

ARM loans can appear complicated, so don't be afraid to ask questions and research your options prior to choosing a mortgage.

 

Adjustable-Rate Loans

With an adjustable-rate mortgage (ARM), the interest rate you pay is adjusted from time to time to keep it in line with changing market rates. This means that when interest rates go up, your monthly mortgage payments may go up as well. On the other hand, when interest rates go down, your monthly mortgage payments may also go down.

ARMs are attractive because they may initially offer a lower interest rate than fixed-rate mortgages. Since the monthly payments on an ARM start out lower than those of a fixed-rate mortgage of the same amount, you can qualify for a larger loan. The chief drawback, of course, is that your monthly payments may increase when interest rates go up.

You may want to consider an ARM if you are confident your income will rise enough in the coming years to comfortably handle any increase in payments. You may also want to consider an ARM if you plan to move in a few years and therefore are not so concerned about possible interest rate increases. You may also want to consider an ARM if you need a lower initial rate to afford to buy the home you want.

How much your payments can increase will depend on the terms of your mortgage. Before applying for an ARM, be sure you know how high your monthly payments could go -- the so-called "worst-case scenario." An ARM has two "caps" or limits on how large an interest rate increase is permitted: One cap sets the most that your interest rate can go up during each adjustment period and the other cap sets the maximum total amount of all interest adjustments over the life of the loan.

A typical ARM that adjusts annually, for example, may cap the yearly interest rate increases at 2 percent, meaning that the adjusted interest rate can never be more than 2 percent higher than the previous year. And such an ARM may have a lifetime rate cap of 6 percent, meaning that the highest adjusted interest rate you can ever be required to pay is no more than 6 percent above the original rate. So, if you are looking at an ARM with a current introductory rate of 5 percent, a lifetime cap of 6 percent tells you that the highest interest rate you could ever pay would be 11 percent. Only you can determine if you would feel comfortable paying this interest rate sometime in the future.

Some ARMs offer a conversion feature, which allows you to convert from an adjustable-rate to a fixed-rate loan at only certain times during the life of your loan. Ask your lender about this feature when researching ARMs.

One important thing to know when comparing ARMs is that the interest rate changes on an ARM are always tied to a financial index. A financial index is a published number or percentage, such as the average interest rate or yield on Treasury bills. The most common types of ARMs are listed below.