What is Adjustable Rate Mortgage (ARM)?
An adjustable rate mortgage, variable rate mortgage or floating rate mortgage is a mortgage where the interest rate on the note is periodically adjusted based on an index. This is done to ensure a steady margin for the lender, whose own cost of funding will usually be related to the index. Consequently, payments made by the borrower may change over time with the changing interest rate (alternatively, the term of the loan may change). This is not to be confused with the graduated payment mortgage, which offers changing payment amounts but a fixed interest rate.
Other forms of mortgage loan include interest only mortgage, fixed rate mortgage, negative amortization mortgage, discounted rate mortgage and balloon payment mortgage. Adjustable rates transfer part of the interest rate risk from the lender to the borrower. They can be used where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate falls and loses out if interest rates rise. ARM Terminology:
- Index: 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.
Consider an Adjustable Rate Mortgage if you:
- Want or need more home than you can qualify for now at a fixed rate.
- Are confident your income will increase.
- Plan on moving within seven years of buying your home.
What are the Advantages of Adjustable Rate Mortgage (ARM)?
Adjustable Rate Mortgage or ARM: First of all let us understand the term adjustable rate mortgage before divulging any further details. It is actually a home loan with an interest rate that fluctuates with interest rate changes determined by indexes from the US Treasury and Federal Reserve Board. Rates may change on rotating monthly, quarterly, one, three or five year term over the period of whole life of a 30 year loan. For example if you have 5/1 ARM, the interest rate is fixed for the first five years and then the rate is adjusted once each year Those who plan to stay in a home for short duration of time may consider ARM as an ideal loan option.
Many people when they first think about ARM they think about risks associated with it. This perception is may be due to new stories that keep on floating in the market. But actually the truth is many consumers have benefited from ARM's and prefer to use them as a tool to save large chunks of money. Current market conditions are once again in favor of ARM's so it is better to understand its benefits.
Lower initial interest rate: The main reason that many people now consider ARM is that they may end up with a lower monthly payment. The bank rewards you with lower initial interest rate because you are taking the risk of higher interest rates in future which is a contrast with the situation of fixed rate mortgage, where bank takes the risk.
Open up new possibilities with money: If you are paying low interest rates it means you have more money with you which opens new possibilities liked you can save it, spend it or make your new assets etc.
You can easily relocate and plan for retiring: With ARM's you can easily relocate according to your job requirements and enjoy lower monthly payments. You can even plan for retiring and making extra payments to pay down the loan faster due to ARM's lower interest rate.
Consumer friendly hybrid ARMs: These types of mortgages can start out as a fixed rate mortgage and gradually morph into adjustable rate mortgages after a specific period of time. For example a 3/1 has fixed interest rate for three years and then an adjustable rate mortgage.
Caps protects its borrowers: ARM's come with an annual and lifetime caps which prevents interest rates to rise above the certain level during the period of 12 months or during the whole life time of a loan which is also a great advantage for the borrower.
A good idea to be in the house for few years: ARM is a good idea if you are planning to be in the house only for the few years. You can save money on interest payments in the short term and will have moved or sold your house before the interest rate approaches.
Terms and Conditions of Adjustable Mortgage Rates
Buying a home is always an exciting event of one's life and is the most exhaustive as well because the earnings of your whole life are on stake. Just like there are different homes to choose from, in the same way there are different types of mortgage plans are available in the market and to choose best among them is really a tough task because each mortgage plan has its own different advantages and disadvantages. While some homebuyers look for predictable and fixed rate mortgages because they don't want to take any further tensions while others want to take the benefits from adjustable rate mortgages. No matter what type of loan suits you, it is better to be aware of various terms and conditions of these types of loans to avoid any future tensions.
Here we discuss terms and conditions of ARM that you must be aware of when talking to your mortgage banker to determine if this loan program is a good match for your financial situation.
You need to consider few conditions before taking ARM's
- Is my income is enough or likely to rise enough to cover higher mortgage payment if interest rates go up
- Whether I will be able to take other sizable debts such as loan for a car, or child's college fee in near future
- How much time it will take to own this home
- Whether I want to pay off the loan early or planning for any sort of additional
- Terms use in Adjustable Mortgage Loan
- Index and margin: The interest rate on ARM is made up of two parts the index and the margin. The index is a measure of the interest rate and margin is the extra amount that lender adds. The index may increase or decrease at any time
- Interest rate caps: It places a limit on the amount your interest rate can increase. Interest rates come in two versions
- Periodic adjustment cap: It limit the amount the interest rate can adjust up or down from one adjustment period to the next after the first adjustment.
- A lifetime cap: It limits the interest rate increase over the life of a loan. By Law, virtually all ARM's must have a lifetime cap.
- Payment caps: In addition to interest rate caps many ARM's including Payment option ARMs which caps or limit the amount of your monthly payment which may increase at the time of each adjustment.
It is important to note knowing the maximum amount you could end up paying on your ARM is important because it will help you in deciding if it is best to refinance prior to the expiration of the fixed rate or continue to allow the rate to adjust because it is still cost-effective.