Adjustable Rate Mortgages:
Adjustable-rate mortgages (ARMs) are popular because they
usually start with a lower interest rate and a lower monthly
payment. The lower rate (and lower monthly payments) may
also allow a higher loan amount. However, the interest rate
can change during the life of the loan, which would mean
that your monthly payment would increase (or decrease).
It's important to understand the specifics of an adjustable-rate
mortgage, commonly called an ARM:
1.) Adjustment periods
All ARMs have adjustment periods that determine when and
how often the interest rate can change. There is an initial
fixed-rate period during which the interest rate doesn't
change - this period can range from as little as 1 month
to as long as 10 years. After the initial period, the interest
rate will often adjust each year. For example, with a 3/1
ARM, your interest remains the same during the first 3 years,
and then can adjust every year following, up to a maximum
amount (the "lifetime cap").
2.) Indexes and margins.
At the end of the initial period and at every adjustment
period, the interest can change based on two factors: the
"index" and the margin. Interest rate adjustments
are based on a published index. There are many indexes but
some commonly used for ARMs are the LIBOR and the U.S. Treasury
Bill. The rates for indexes reflect current financial market
conditions, which is why your interest rates can change
at each adjustment period. The margin is the amount (shown
as a percentage) that is added to the index to determine
what your new mortgage rate will be until the next adjustment
period.
3.) Caps, ceilings, and floors.
All ARMs have rate caps, also known as ceilings and floors.
Caps decide how much the interest rate can increase or decrease
at each adjustment period and over the life of the loan.
Most ARMs have a lifetime cap that limits the amount your
interest rate can increase over the life of your mortgage.
4.) The number system.
There are several types of ARMs, such as the 10/1, 7/1,
5/1 and 3/1. The first number (10 for example) is the length
of the initial period, during which the interest rate can't
change. The second number (1 for example) is how often the
ARM is adjusted after the initial period. So, a 10/1 ARM
won't change for the first 10 years, but can change in the
11th year and again every year after that. Depending on
the initial cap the change could be as high as 5 percentage
points above what it was before.
There are additional considerations
to be aware of with Adjustable Rate Mortgages:
1.) Because the initial interest rate is usually lower than
a fixed-rate mortgage, your initial payments will be lower
and you may qualify for a larger mortgage amount.
2.) If interest rates are high when you get your mortgage
but drop during any adjustment period, your monthly payment
may decrease.
3.) An ARM with a low initial interest rate and an initial
adjustment period after 5 or 7 years can save you money.
4.) ARMs can, and often do, have interest rate increases
at adjustment periods. You may have an increase in your
monthly mortgage payment after each adjustment period. The
amount your mortgage might increase would depend on the
periodic cap (how much of an increase is allowed each year),
the lifetime cap (the maximum interest rate or maximum number
of increases allowed), and the size of your mortgage's margin.
If the life cap is 5%, the maximum interest rate adjustment
would be to 10.75%
