Adjustable Rate Mortgage Loan Facts

Is an ARM Right For Me?

An ARM, or Adjustable Rate Mortgage Loan, is a loan term mortgage that is determined by the changing economic index. You have changing rates and monthly payments modified higher or lower depending on the changing index.

ARM Terms

Index

An index is the standard that is used by lenders to determine changes in the interest rate. They monitor very frequently the activities of 1, 3, & 5 year Treasury securities, but there are several other factors as well. Each individual Adjustable Rate Mortgage is tied to an individual index.

Margin

This can basically be described as the markup created by the lender. This is representative of the lender's cost of doing the loan added to the profit they expect to make on the loan. When you add the index to the margin you can equate your total interest rate. Many times it can stay the same during the term of your adjustable rate loan.

Adjustment Period

This is the amount of time between your interest rate adjustments.
Many times the ARM is defined by certain figures such as 1-1, 3-1, or 5-1. The first number represents the first period of the loan. During this term your interest rate will stay the same as when you first signed the loan documents. The second figure is the actual adjustment period. This is how often adjustments can be applied to the rate after the first period has ended. Those above examples all reflect yearly adjustments.

If my payments can go up, why should I consider an ARM?

Well, at the beginning of the term of the adjustable rate mortgage loan, the interest rate for an ARM will be quite a bite lower than if you went with a fixed mortgage rate. With a lower rate you get a lower payment which allows you to qualify for a bigger loan.
One question you need to ask yourself is how long do you plan to own the house? The likelihood of an increased rate isn’t usually as much of a factor if you figure you will sell the home within a few years anyways.
Are you expecting your level of income to increase? If you are, then the extra income will help you to deal with the higher payments that will result in increased rates later on during the life of the loan.
Some ARMS have the advantage of being able to be converted into a fixed rate mortgage. However, sometimes converting the loan results in high conversion fees which of course could completely deplete any savings you would have made through the beginning low rate.

ARM Indexes

Now as a borrower we don’t have the ability to choose which index your lender will use. However, you can opt to make a decision on your loan and lender by basing it on which index will be applicable to your loan. You should research and find out how each of the indexes used performed over the past several years. In your search you are looking to find and index that is joined to an ARM that has had stability over several years. While you are searching out possible lenders to use make sure to keep in consideration the offered index and the margin rate both.

Discounted Rates and Buydowns

Many times when buying a home you run the possibility of encountering sellers who will make an offer of what’s called a “buydown fee”. This gives the lender the ability to make a lower initial offer on your rate than what the index and margin are currently at. Many times this strategy is used be new home builders as a way to help get people to purchase their homes.

This “buydown rate” has an actually expiration date however and you could see a significant increase to your payments if the ARM has an upwards adjustment at the similar time that your discount reaches its expiration. Always be mindful that there are many times that the sellers will raise a home purchase price in order to cover the difference of them buying down your loan. This extra cost could possibly override what savings you would have had from the original discount.

Interest Rate Caps

Rate caps keep a ceiling on how much interest can be charged against your loan. There are two different kinds of interest rate caps that can be associated to the ARMs.

• Periodic caps put a limit on the measure that your interest rate is allowed to increase from one period of adjustment to the next. Every ARM does not have periodic rate caps necessarily.

• Overall caps put a limit on the measure that your interest rate is allowed to increase over the life of the loan. Since 1987 the government has required that all ARMs be fitted with an overall cap.

Payment Caps

It is very common for adjustable rate mortgage loans to have a payment cap instead of a periodic rate cap. In these scenario’s they put a limit as to how much your monthly mortgage payment can be raised at each adjustment.

Carryovers

One thing to also be mindful of is that even if an interest rate cap keeps down your interest during an adjustment that the index was raised, that amount of the raise could be carried over into the next adjustment period.

Beware of Negative Amortization

When payments are made to a home loan Amortization occurs when the payments cover both the current interest due as well as part of the principle.

When payments do not cover the interest costs what’s called Negative amortization occurs. This unpaid amount is added back on to the amount of the loan. In this case it ends up generating even more interest debt. When this occurs it puts you into a position where even though you are making many payments you still end up owing more than you did at the beginning of the loan. It is a quickly increasing debt. This usually occurs when a payment cap is put on a loan that keeps monthly payments from covering interest costs.

The Bottom Line

It is required of lenders that they provide you with written information that will help you to compare mortgages and select the one that is right for you. Do not be afraid to ask many, many questions. You want to make sure you fully understand every aspect of an adjustable rate mortgage loan as well as other home loans that may be offered to you.