| What
is an Adjustable rate Mortgage?
Adjustable-rate mortgages
(commonly called an ARM) 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:
- 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").
- 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.
- 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.
- 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.
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