Adjustable Rate Mortgage (ARM) is a mortgage loan which allows the lender to make interest rate adjustments by referring to a national index. The major advantage of an ARM to the borrower is greater affordability. The interest rate is lower than the market rate at the inception or first few years of the loan.
The ARM loan has caps on interest rate adjustments, annually and over the life of the loan. Unfortunately, many consumers have been negatively affected by the sub-prime mortgage crisis which centers around ARM loans.
While the lower initial interest rate of ARM loans affords the opportunity of home ownership to more people, that home ownership comes with greater risks. When considering an adjustable rate mortgage loan it is important that you understand your options before you sign any loan documentation.
Do not trust your mortgage broker, lender or bank loan officer to fully explain the risks. Do your own research and even consult an attorney if possible.
Features of Adjustable Rate Mortgages Index rate. A guide that lenders use to determine interest rate changes. Lenders use many rate indexes but the most common are one, three, or five-year Treasury Securities. Each Adjustable Rate Mortgage is linked to a specific index.
Margin. The percentage points or mark-ups that a lender adds to the index rate. The index rate and margin determines the ARM’s total interest rate. The margin is an interest rate that represents the lender's cost of doing business along with the profits the lender makes during the life of the loan.
Initial interest rate. The interest rate on an ARM at its inception. Initial Discounts. Interest rate concessions that reduce the interest rate below the current rate usually offered for the first year of the loan.
Adjustment period. The period of time where the ARM interest rate remains unchanged. At the end of the adjustment period the interest rate resets and the monthly mortgage payment is recalculated. When you see an ARM described (1-1); (3-1); and (5-1), the first number denotes the initial period of the loan where your interest rate will stay the same as the day of the inception of the loan. The second number denotes how often adjustments can be made to the interest rate after the initial period has ended.
Interest rate caps. Rate caps limit how much the interest rate or monthly mortgage payment can be changed at the end of the adjustment period. Adjustable Rate Mortgages have two types of interest rate caps: (1) Periodic Caps which limit the amount interest rates can increase from one adjustment period to another and (2) Overall Caps which limit the amount an interest rate can increase over the life of the loan.
Payment caps. Limits on how much a monthly mortgage payment can increase at each adjustment period. Borrowers should take note that payment caps without corresponding interest caps can result in negative amortization where the unpaid interest portion is added to the outstanding balance of the loan.
Negative amortization. Basically negative amortization means the mortgage balance is increasing. The increase in mortgage balance is directly related to the amount of deficiency in interest payment due on the mortgage. This occurs whenever the monthly mortgage payments are not large enough to pay all the interest due on the mortgage. When negative amortization occurs, you not only add to the balance of the loan but that interest added to the balance generates even more interest debt.
Conversion. A clause in the loan which allows the borrower to convert an Adjustable Rate Mortgage to a Fixed Rate Mortgage (FRM) at a designated time.
Prepayment. A clause in the loan agreement that requires the borrower to pay special fees or penalties to pay off the ARM loan early. These penalties are often steep but they can be negotiated.
Discounted rates and buydowns. An upfront fee that allows the lender to offer an initial lower interest rate than the sum of the index and the margin. Buydown rates eventually expire and your payments could significantly rise.
Option ARM. Adjustable Rate Mortgages which provide borrowers “flexibility” or “options” in making monthly payments. The rate adjusts monthly and is based on the index added to the margin rate. Some of the options in payment are: Interest Only; Fully Amortizing 30-Year Payment; Fully Amortizing 15-Year Payment and Minimum Payment.
Option Arms contain a variety of rate adjustments that depend on indexes increasing or decreasing. The advantage in an Option ARM is that the borrower has the ability to choose which type of payment he or she makes depending on their financial condition in a given month. One of the main disadvantages is that the borrower may end up with negative amortization.
Some of the most common rate indexes are the Constant Maturity Treasury (CMT), Cost of Funds Index (COFI), 12-month Treasury Average Index (MTA), Bank Bill Swap Rate (BBSW) and the London Interbank Offered Rate (LIBOR).
