Adjustable rate mortgages are sometimes confused with graduated payment mortgages. With a graduated payment mortgage the interest rate remains fixed while the payment amounts change.



With adjustable rate mortgages much of the interest rate risk is transferred from the lender to the borrower. Borrowers benefit when interest rates on the mortgage fall. On the other hand, borrowers lose out when interest rates rise. Usually the loans are available when fixed rate mortgages are more difficult to obtain.

Key Terminology

Index - the guide used by lenders to measure changes in the interest. Each adjustable rate mortgage is linked to an index.

Margin - the part of the interest rate from which the lenders profits. The margin plus the index rate is the total interest rate. While the index will change throughout the duration of the adjustable rate mortgage, the margin will not.

Adjustment period - the period between interest rate adjustments, usually denoted in the format of 1-1. The first number is the initial period of the loan for which the interest rate will remain the same. The second number is the adjustment period. It shows denotes the frequency at which the interest rate can be adjusted.

Loan Choosing Tips

The index is one of the most important considerations in choosing an adjustable rate mortgage. Even though you don't have control over the specific index that is used by a particular lender, you can choose a loan and lender according to the index that will apply to the particular loan in which you are interested.

A lender you are considering can give you an indication of the performance of the loan in the past. The ideal loan is one that has an index that has historically remained stable. As you consider loans and lenders, make sure you also consider the margin rate that the lender offers.

Many borrowers wonder about the benefits of an adjustable rate mortgage since the payments can increase over time. In most cases, the benefit of an adjustable rate mortgage comes into play when the interest rate of the ARM is lower than the fixed rate mortgage. The possibility of a payment increase is sometimes inconsequential. This is true if you do not plan to occupy the house for an extended period or if you expect your income to increase over the life of the loan.

Avoid Negative Amortization

Negative amortization is a key watch-out when you are choosing an adjustable rate mortgage. This can occur when a particular loan as a cap on payments that keeps them from covering the amount of interest on the mortgage. As a result, unpaid interest is added to the loan, causing the amount of the loan to increase, even though you are making payments.

You can start out with a positive amortization on your adjustable rate mortgage but end up with a negative one due to interest rate increases. The best way to avoid negative amortization is to avoid adjustable rate mortgages that have a payment cap.