When shopping for different mortgages and
mortgage rates it is especially important to take the length and structure of the mortgage into consideration among other things.
As the name suggests, an adjustable rate mortgage (ARM) is one with a fluctuating interest rate. While considered riskier than a conventional fixed rate mortgage, an ARM can provide numerous financial benefits for borrowers in certain situations. Therefore, before considering an ARM it is best to understand the key aspects of these mortgages and how they work.
How ARM Interest Rates are Calculated
The interest rate on an ARM is linked to an economic index. In the US, there are six commonly-used indices, including the London Interbank Offered Rate, the Constant Maturity Treasury, and the Cost of Funds Index. The indices increase and decrease according to economic activity, and the interest rate on the ARM adjusts accordingly. Depending on the terms and conditions of each ARM, these adjustments might be made annually, or two to three times a year.
The interest rate that a lender quotes is comprised of the index figure plus a margin that represents the profit the lender makes on the loan. Unlike the index, the margin usually stays constant throughout the life of the ARM. Your mortgage note will include this information, stating the index your interest rate is based on, as well as the margin.
Adjustment Periods
The adjustment period of an ARM is the time period between interest rate adjustments. In most cases, the adjustment period is one year, but can also be as low as one month for some ARM's. Adjustable Rate Mortgages are typically hybrid mortgages that are amortized over a thirty year period. The rate of the hybrid ARM is depicted by the fixed rate followed by the adjustable rate. For example, a 3/27 means that the mortgage has a fixed interest rate for the first three years, and the rate is adjustable for the remaining 27 years. Likewise, a 2/28 ARM would mean that the rate is fixed for the first 2 years and adjustable for the remaining 28 years. The exception to this pattern is the 5/6 ARM. This amortization period of a 5/6 ARM is still thirty years, however the adjustment period is every six months for the life of the loan and not six years.
Payment Caps
ARMs have payment caps, meaning there is a limit on how much the interest rate can increase or decrease at each adjustment, and over the life of the loan. There are three different types of caps—initial, periodic, and lifetime caps.
