An Adjustable Rate Mortgage or ARM is a type of mortgage loan in which the interest rate and monthly payment remains the same throughout a certain period, which is usually one, three, five, seven, or ten years. After the fixed period, the rate may or may not rise but if it does, the increase would be at intervals. As far as the amount of increase, this would range between .05% and 2% each time increased. Keep in mind that with an ARM, there is a cap on the margin, which is determined by the highest rate that the interest can go.
An ARM offers a number of advantages over other types of loans to include the option of securing a lower rate for the fixed period. For instance, first time homebuyers would benefit with a lower mortgage payment while they become established. After the fixed period is over, the homeowner could refinance to lock in better interest rates. In other words, let us say the initial ARM had an interest rate at 5%. However, at the end of the fixed period, the rate had increased to 6.5%. Now, at that time, if the current rate were 5.5%, then you could refinance, locking into the lower 5.5% rate.
Many people are drawn to an ARM over a Fixed Rate Mortgage (FRM) due to the lower interest rate and being able to qualify for a larger loan amount. While an FRM is more predictable with monthly payments remaining the same, they are not for everyone. As you will see below, there are certain terms associated with an ARM that you should learn so you can make an educated decision when it comes time to choose the best loan for your mortgage.
Index – Guide used by lenders to measure interest rate changes, which include activity of one, three, and five-year Treasury securities among other things
Margin – Lender’s markup, which is the interest rate representing the lender’s cost of doing business in addition to profit made on the loan
Adjustment Period – Time between potential interest rate adjustments
Discounted Buy-downs and Rates – Potential fee allowing lenders to offer the buyer an initial rate lower than the sum of the index and margin
Interest Rate Caps – Limits the amount of interest that can be charged
Negative Amortization – Occurs when payments are large enough to pay the interest plus a portion of the principal
Bottom Line – Written information to help you compare and select the right mortgage