Facts about Adjustable Rate Mortgages (ARMs)
In short, an adjustable rate mortgage, also known as an ARM, is a
mortgage loan which features an interest rate that changes based on
changes to a particular economic index. The interest rate, and
therefore, the monthly mortgage payment you must pay, changes over time
as the underlying index changes.
Adjustable Rate Mortgage (ARM) Terms
There are a number of terms that are specific to the world of ARMs, and
it is important to understand what these terms mean. You will likely
hear these words bandied about often as you shop for your adjustable
The index is a guide used by lenders in order to measure changes in
interest rates. Some of the indexes used by lenders include the one,
three and five year Treasury security, but there are many other indexes
used by mortgage lenders. It is important for shoppers to know which
index their interest rate is linked to.
The margin is the markup on the index. It is the difference between the
interest rate on the underlying index and the rate the home buyer will
have to pay. It is important to understand what the margin is, and to
understand how it will affect your monthly mortgage payments.
The adjustment period is the period between those potential adjustments
in interest rates. This adjustment period can vary quite widely, and
again it is important to understand how often the interest rate, and
monthly mortgage payment, can change.
Many people are uncomfortable with the idea that their interest rate,
and monthly mortgage payment, can go up over time. In order to overcome
this reluctance, lenders typically offer a lower initial interest rate
on ARMs than on similar fixed rate mortgages. This lower initial
interest rate results in lower monthly mortgage payments, and it can
help make homes more affordable, particularly for first time home
ARMs are also a good choice for those buyers who do not plan to remain
in the home for a long period of time. For these short term buyers the
risk of rising interest rates is mitigated by their short time horizon.
While some adjustable rate mortgages can be converted into fixed rate
mortgages, in many cases the conversion fees are quite high. It is
important to read the fine print of your ARM in order to determine if
such a conversion is a real option.
Home buyers need to carefully review the various indexes to which various ARMs are linked. It is important to understand the index used by the
lender, and to understand how often the interest rate could potentially
change. The goal should be to find an index that is likely to remain
fairly stable. Avoiding large swings, especially when they are
increases, is important when dealing with an adjustable rate mortgage.
Interest Rate Cap
When shopping for an adjustable rate mortgage, it is also important to
understand just how high the interest rate can go. The interest rate cap
on an ARM serves to limit how much interest the homeowner can be
charged. The different types of caps on ARMs are:
The Periodic Cap
The periodic cap limits the amount the interest rate can increase from
one period to the next. Not every adjustable rate mortgage will contain
a periodic cap, and those that do not could see the interest rate rise
an unlimited amount from one adjustment period to the next.
The Overall Cap
The overall cap limits how much the interest rate can go up over the
entire life of the mortgage loan. Since 1987, all ARMs are required to
have an overall cap in place.
The Payment Cap
The payment cap is a limit on how much the monthly mortgage payment can
increase with each adjustment period. An adjustable rate mortgage with a
payment cap may not have a periodic rate cap as well.
Other Common ARM Terms
In addition to the various types of caps on adjustable rate mortgages,
there are a number of other terms shoppers often hear bandied about.
These common ARM terms include:
The carryover comes into play when the interest rate has been held down
by an interest rate cap even though the underlying index has gone up. In
this case the carryover is the amount of that increase that will be
carried over into the next period of adjustment.
Negative amortization is what happens when the payments made on the
mortgage are not enough to cover the interest due on the loan. In this
case, the unpaid amounts are added back into the loan, resulting in the
generation of still more interest debt. If this process of negative
amortization continues, it could result in the home buyer owing ever
more money even while making regular payments.