Adjustable Rate Mortgage (ARM) Fact Sheet
By Janet Meyers
05/31/2006
Adjustable rate mortgages, or ARMs are loans based on published industry indexes. An index is simply a statistical report used as an indicator for the approximate change in the cost of money. There are a number of recognized and globally accepted index reports that are used to set standards for ARM rates. Some of these include US Treasury rates such as the Prime Rate, MTA, CMT, COFI, COSI, CODI and LIBOR.
When an adjustable rate mortgage is issued, it is based on the lender’s preferred index. Your interest rate on the loan will then fluctuate based on this index. The index is more or less a break-even point for the lender, so typically they will add a margin of two to three percent in order to turn a profit and pay for administrative expenses. The sum total of the index and the margin yields the adjustable interest rate on your loan. Only the index should rise or fall – the margin will remain constant for the life of the loan. To illustrate the Margin, let us assume that the mortgage interest rate is 7%. If the current index rate is 5%, then the margin is 7% - 5% = 2%.
The interest rate charged for an ARM will be recalculated at specific intervals. This is known as the Rate Adjustment Period. Typically, this can be six months, a year, or every few years. Depending on how high or low the current index is, you may opt for a longer or shorter period if possible, though annual adjustments are the most common. One safety measure built into an ARM is an interest rate cap. An interest rate cap is where there is an upper limit to the interest rate you will pay on the loan. Another is a payment cap. This is where an upper limit exists for the size of the payment you must make each month. These mechanisms are in place to prevent “payment shock.” Simply put, lenders want to make sure you will be able to make your payments, so they don’t want to put you in a position where you end up defaulting on your loan. In this respect, they are on the same side as you. Fannie Mae and Freddie Mac have rate adjustment guidelines along these lines, limiting increases to two percent per year and five percent over the life of the loan.
One final note, be careful of teaser rates. These are special terms, usually for the first year of the loan to hook you in. The problem is that after the year is up, the rate jumps to a much higher level than you may be prepared to pay. The savings will certainly be there during the first year, but you need to look at the long term loan before making any decisions. A teaser rate exists for two purposes: to compete with other lenders by offering an initial rate so low that it is almost impossible to refuse and to hook you in to their product before someone else snatches you up as a customer.
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