mortgages (ARMs) differ from fixed-rate mortgages
in that the interest rate and monthly payment can
change over the life of the loan. ARMs also generally
have lower introductory interest rates vs. fixed-rate
mortgages. Before deciding on an ARM, key factors
to consider include how long you plan to own the property,
and how frequently your monthly payment may change.
choose an adjustable-rate mortgage?
low initial interest rates offered by ARMs make them
attractive during periods when interest rates are
high, or when homeowners only plan to stay in their
home for a relatively short period. Similarly, homebuyers
may find it easier to qualify for an ARM than a traditional
loan. However, ARMs are not for everyone. If you plan
to stay in your home long-term or are hesitant about
having loan payments that shift from year-to-year,
then you may prefer the stability of a fixed-rate
of adjustable-rate mortgages
Adjustable-rate mortgages have three primary components:
an index, margin, and calculated interest rate.
The interest rate for an ARM is based on an index
that measures the lender's ability to borrow money.
While the specific index used may vary depending
on the lender, some common indexes include U.S.
Treasury Bills and the Federal Housing Finance Board's
Contract Mortgage Rate. One thing all indexes have
in common, however, is that they cannot be controlled
by the lender.
The margin (also called the "spread")
is a percentage added to the index in order to cover
the lender's administrative costs and profit. Though
the index may rise and fall over time, the margin
usually remains constant over the life of the loan.
- Calculated interest
By adding the index and margin together, you arrive
at the calculated interest rate, which is the rate
the homeowner pays. It is also the rate to which
any future rate adjustments will apply (rather than
the "teaser rate," explained below).
periods and teaser rates
Because the interest rate for an ARM may change due
to economic conditions, a key feature to ask your
lender about is the adjustment period--or how often
your interest rate may change. Many ARMS have one-year
adjustment periods, which means the interest rate
and monthly payment is recalculated (based on the
index) every year. Depending on the lender, longer
adjustment periods are also available.
An ARM can
also have an initial adjustment period based on a
"teaser rate," which is an artificially
low introductory interest rate offered by a lender
to attract homebuyers. Usually, teaser rates are good
for 6 months or a year, at which point the loan reverts
back to the calculated interest rate. Remember, too,
that most lender will not use the teaser rate to qualify
you for the loan, but instead use a 7.5% interest
rate (or calculated interest rate if it is lower).
To protect homebuyers from dramatic rises in the interest
rate, most ARMs have "caps" that govern
how much the interest rate may rise between adjustment
periods, as well as how much the rate may rise (or
fall) over the life of the loan. For example, an ARM
may be said to have a 2% periodic cap, and a 6% lifetime
cap. This means that the rate can rise no more than
2% during an adjustment period, and no more than 6%
over the life of the loan. The lifetime cap almost
always applies to the calculated interest rate and
not the introductory teaser rate.
caps and negative amortization
Some ARMs also have payment caps. These differ from
rate caps by placing a ceiling on how much your payment
may rise during an adjustment period. While this may
sound like a good thing, it can sometimes lead to
if the interest rate rises during an adjustment period,
the additional interest due on the loan payment may
exceed the amount allowed by the payment cap--leading
to negative amortization. This means the balance due
on the loan is actually growing, even though the homeowner
is still making the minimum monthly payment. Many
lenders limit the amount of negative amortization
that may occur before the loan must be restructured,
but it's always wise to speak with your lender about
payment caps and how negative amortization will be