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Mortgage
Glossary | All About Adjustable Rate
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Adjustable-rate mortgages
(ARMs) differ from fixed-rate mortgages in that the interest
rate and monthly payment can change over the life of the loan.
ARMs also generally have lower introductory interest rates
vs. fixed-rate mortgages. Before deciding on an ARM, key factors
to consider include how long you plan to own the property,
and how frequently your monthly payment may change.
Why choose an adjustable-rate
mortgage?
The low initial interest rates offered by ARMs make them attractive
during periods when interest rates are high, or when homeowners
only plan to stay in their home for a relatively short period.
Similarly, homebuyers may find it easier to qualify for an
ARM than a traditional loan. However, ARMs are not for everyone.
If you plan to stay in your home long-term or are hesitant
about having loan payments that shift from year-to-year, then
you may prefer the stability of a fixed-rate mortagage.
Components of adjustable-rate
mortgages
Adjustable-rate mortgages have three primary components: an
index, margin, and calculated interest rate.
- Index
The interest rate for an ARM is based on an index that measures
the lender's ability to borrow money. While the specific
index used may vary depending on the lender, some common
indexes include U.S. Treasury Bills and the Federal Housing
Finance Board's Contract Mortgage Rate. One thing all indexes
have in common, however, is that they cannot be controlled
by the lender.
- Margin
The margin (also called the "spread") is a percentage
added to the index in order to cover the lender's administrative
costs and profit. Though the index may rise and fall over
time, the margin usually remains constant over the life
of the loan.
- Calculated interest rate
By adding the index and margin together, you arrive at the
calculated interest rate, which is the rate the homeowner
pays. It is also the rate to which any future rate adjustments
will apply (rather than the "teaser rate," explained
below).
Adjustment periods and
teaser rates
Because the interest rate for an ARM may change due to economic
conditions, a key feature to ask your lender about is the
adjustment period--or how often your interest rate may change.
Many ARMS have one-year adjustment periods, which means the
interest rate and monthly payment is recalculated (based on
the index) every year. Depending on the lender, longer adjustment
periods are also available.
An ARM can also have
an initial adjustment period based on a "teaser rate,"
which is an artificially low introductory interest rate offered
by a lender to attract homebuyers. Usually, teaser rates are
good for 6 months or a year, at which point the loan reverts
back to the calculated interest rate. Remember, too, that
most lender will not use the teaser rate to qualify you for
the loan, but instead use a 7.5% interest rate (or calculated
interest rate if it is lower).
Rate caps
To protect homebuyers from dramatic rises in the interest
rate, most ARMs have "caps" that govern how much
the interest rate may rise between adjustment periods, as
well as how much the rate may rise (or fall) over the life
of the loan. For example, an ARM may be said to have a 2%
periodic cap, and a 6% lifetime cap. This means that the rate
can rise no more than 2% during an adjustment period, and
no more than 6% over the life of the loan. The lifetime cap
almost always applies to the calculated interest rate and
not the introductory teaser rate.
Payment caps and negative
amortization
Some ARMs also have payment caps. These differ from rate caps
by placing a ceiling on how much your payment may rise during
an adjustment period. While this may sound like a good thing,
it can sometimes lead to real trouble.
For example, if the interest
rate rises during an adjustment period, the additional interest
due on the loan payment may exceed the amount allowed by the
payment cap--leading to negative amortization. This means
the balance due on the loan is actually growing, even though
the homeowner is still making the minimum monthly payment.
Many lenders limit the amount of negative amortization that
may occur before the loan must be restructured, but it's always
wise to speak with your lender about payment caps and how
negative amortization will be handled.
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