An Adjustable-Rate Mortgage (ARM) is any mortgage that does not have an interest rate that remains fixed for the life of the loan. Adjustable rates only remain fixed for a short period of time depending on how the loan was structured but will adjust every so often based on the adjustment period. An adjustable-rate can adjust up or down with the market conditions and can make your payments go up or down accordingly. There are caps on how much an adjustable rate can increase at one time as well as a cap on how much it can increase over the lifetime of the loan.
Adjustable-Rate Components and Terminology
To understand an ARM, you must have a working knowledge of its components. Those components are:
Index: A financial indicator that rises and falls, based primarily on economic fluctuations. It is usually an indicator and is therefore the basis of all future interest adjustments on the loan. Mortgage lenders currently use a variety of indexes.
Margin: A lender’s loan cost plus profit. The margin is added to the index to determine the interest rate because the index is the cost of funds, and the margin is the lender’s cost of doing business plus profit.
Initial Interest: The rate during the initial period of the loan, which is sometimes lower than the note rate. This initial interest may be a teaser rate, an unusually low rate to entice buyers and allow them to qualify for the loan more readily.
Note Rate: The actual interest rate charged for a particular loan program.
Adjustment Period: The interval at which the interest is scheduled to change during the life of the loan (e.g., annually).
Interest Rate Caps: Limit placed on the up-and-down movement of the interest rate, specified per period adjustment and lifetime adjustment (e.g., a cap of 2 and 6 means a 2% interest increase maximum per adjustment with a 6% interest increase maximum over the life of the loan).
Negative Amortization: Occurs when a payment is insufficient to cover the interest on a loan. The shortfall amount is added back onto the principal balance.
Convertibility: The option to change from an ARM to a fixed-rate loan. A conversion fee may be charged.
Carryover: Interest rate increases more than the amount allowed by the caps that can be applied at later interest rate adjustments (a component that most newer ARMs are deleting).
Is an adjustable-rate right for you?
An adjustable rate is beneficial when you need a lower interest rate to qualify or if you know you won't stay in the same home past the first adjustment period. Adjustment periods can make significant impacts on your monthly payment which can hurt if you're not prepared. If you have questions or are wondering if an adjustable rate is right for you then give one of our experienced loan officers a call!