An index is a guide that lenders use to measure interest rate changes. Common indexes used by lenders include the activity of one, three, and five-year Treasury securities, but there are many others. Each ARM is linked to a specific index. Margin
Think of the margin as the lender's markup. It is an interest rate that represents the lender's cost of doing business plus the profit they will make on the loan. The margin is added to the index rate to determine your total interest rate. It usually stays the same during the life of your home loan. Adjustment Period
The adjustment period is the period between potential interest rate adjustments.
You may see an ARM described with figures such as 1-1, 3-1, and 5-1.
The first figure in each set refers to the initial period of the loan, during which your interest rate will stay the same as it was on the day you signed your loan papers.
The second number is the adjustment period, showing how often adjustments can be made to the rate after the initial period has ended. The examples above are all ARMs with annual adjustments--meaning adjustments could happen every year. If my payments can go up, why should I consider an ARM?
The initial interest rate for an ARM is lower than that of a fixed rate mortgage, where the interest rate remains the same during the life of the loan. A lower rate means lower payments, which might help you qualify for a larger loan.
How long do you plan to own the house? The possibility of rate increases isn't as much of a factor if you plan to sell the home within a few years.
Do you expect your income to increase? If so, the extra funds might cover the higher payments that result from rate increases.
Some ARMs can be converted to a fixed-rate mortgage. However, conversion fees could be high enough to take away all of the savings you saw with the initial lower rate. ARM Indexes
While you can't dictate which index a lender uses, you can choose a loan and lender based on the index that will apply to the loan. Ask the lender how each index used has performed in the past. Your goal is to find an ARM that is linked to an index that has remained fairly stable over many years.
When comparing lenders, consider both the index and the margin rate being offered. Discounted Rates and Buydowns
When you're buying a home you might encounter sellers who offer to pay a buydown fee that allows the lender to offer you an initial rate that's lower than the sum of the index and the margin. New home builders sometimes offer that type of purchase package to help get people into their homes.
The buydown rate will eventually expire and your payments could rise significantly if an ARM rate is adjusted upwards at the same time the discount expires.
Keep in mind that sellers sometimes raise the price of a home by the amount they pay to buydown your loan. The extra cost may in time override any savings from the initial discount. Interest Rate Caps
Rate caps limit how much interest you can be charged. There are two types of interest rate caps associated with ARMs.
* Periodic caps limit the amount your interest rate can increase from one adjustment period to the next. Not all ARMs have periodic rate caps.
* Overall caps limit how much the interest rate can increase over the life of the loan. Overall caps have been required by law since 1987.
Payment Caps
A payment cap limits how much your monthly payment can increase at each adjustment. ARMs with payment caps often do not have periodic rate caps. Carryovers
If an interest rate cap held your interest down at an adjustment even though the index went up, the amount of the increase can be carried over to the next adjustment period. Beware of Negative Amortization
Amortization takes place when payments are large enough to pay the interest due plus a portion of the principal.
Negative amortization occurs when payments do not cover the cost of interest. The unpaid amount is added back to the loan, where it generates even more interest debt. If this continues you could make many payments, but still owe more than you did at the beginning of the loan.
Negative amortization generally occurs when a loan has a payment cap that keeps monthly payments from covering the cost of interest. The Bottom Line
Lenders are required to give you written information to help you compare and select a mortgage. Don't hesitate to ask as many questions as it takes to help you understand every aspect of ARMs and other home loans that are offered to you.
For more information on adjustable rate mortgages, amortization tables, mortgage basics visit Independent Loan Information.
Ironically, despite tough economic times, one of the best times to take advantage of an adjustable rate mortgage can be in the period coming out of a recession when the market and economy as a whole is in an uptrend, because this is the time when lenders are more willing to negotiate rates.
When Is A Good Time For An Adjustable Rate?
When a financial institution or lender offers a fixed rate mortgage to a home buyer, they are taking a risk by betting on the fact that interest rates will not sharply increase during the lifetime of the loan period. If interest rates do go up, they will be locked into a low fixed rate when they could be earning more if it was adjustable.
Conversely, if interest rates are projected to go lower during the lifetime of the loan then this would be a good scenario for the lender and bad for the borrower because they would be stuck at their higher fixed interest rate.
So how do you decide whether now is a good time to go with either a fixed rate or an adjustable rate? Simple: do you project that over the lifetime of your mortgage (usually 5-30 years) interest rates will go up or down?
If they are going to go up, you should get a fixed interest rate to shield yourself from this added risk. If you think they are going to go down, you might want to consider an adjustable rate mortgage so that the interest you pay back can decrease as the overall interest rate decreases.
However, keep in mind that an adjustable rate can always go the other way and you can end up paying back more interest than if you had agreed upon a fixed level.
Why Would a Bank Offer An Adjustable Rate Mortgage?
One of the risks of being a lender and agreeing upon interest rate conditions is that there is always the unknown future volatility that can make interest rates go either up or down. With that idea in mind, your bank would be taking a risk by offering a low fixed rate to you for your loan.
By accepting an adjustable interest rate for the term of your loan, you are also taking on a part of that risk an so you may receive additional benefits such as lower initial payments.
Both Alex Gwen Thomson & Nathan Navachi are contributors for EditorialToday. The above articles have been edited for relevancy and timeliness. All write-ups, reviews, tips and guides published by EditorialToday.com and its partners or affiliates are for informational purposes only. They should not be used for any legal or any other type of advice. We do not endorse any author, contributor, writer or article posted by our team.