Adjustable-Rate Mortgage (ARM)

ARM loans provide a alternative to fixed rate long term financing. The interest rate for the ARM loan changes periodically. Because the lender has the ability to increase or decrease the interest rate they are willing to establish lower rates on these mortgages then is offered on fixed rate mortgages. Many of the ARM loans have an initial period of from five to seven years, during which the interest rate cannot change, making this type of mortgage acceptable to buyers.

Why choose an adjustable-rate mortgage?
Many people choose an ARM loan because they are aware that the average life of a mortgage loan is about 7 years. A five or seven year first period provides the best of the fixed rate mortgage combined with an adjustable rate. If an ARM loan is selected it can be refinanced before the first five or seven-year period is completed. Many buyers plan to sell their homes within the initial period because of family growth or job promotions or changes. If you plan to own the property for an extended period, and do not wish to face a refinance at the end of the initial period you should select a fixed rate mortgage.

Adjustable-rate mortgage
The three primary components of an ARM loan are:

Index
The interest rate for an ARM is based on an index that measures the lender's cost of funds. 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 the lender cannot control them.

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. Recent ARM products feature an initial period which is longer and then provides for shorter periods later.

Be careful if the ARM loan has an artificially low beginning rate only offered to attract borrowers. If you are qualified under one of these short period teaser rates you may find that the payments after the teaser period are unacceptable

Rate caps
To protect homebuyers and lenders from dramatic increases or decreases in the interest rate, most ARMs have "caps" that govern how much the interest rate may rise or fall 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.

Rol/9/02