Real Estate & Mortgage Insights

Understanding Adjustable Rate Mortgages

You've probably heard a lot about ARMs in the news of late, but many people still find them confusing. They know that the rate changes, but they aren't sure how. ARMs really aren't all that complicated.

An ARM, like its counterpart the fixed rate mortgage (or FRM), has two elements: The interest rate and monthly payment. With a fixed rate loan those items stay the same throughout the life of the loan. With an ARM, the interest rate changes and in turn, causes changes in your monthly payments.

It works like this. An adjustable rate mortgage has a period in between rate changes called the adjustment period. A one year ARM has an adjustment rate period of a year, so that's how often the interest rate - and your payments - can change. A 3-year ARM has a 3-year adjustment period, etc.

The interest rate itself has two parts: the index and the margin. The index determines the interest rate. It may be based on CMT securities, the Cost of Funds Index (COFI), the London Interbank Offered Rate (LIBOR) or even the lender's own cost of funds. These indexes vary, with some changing more often than others and some that are generally higher than others. The margin represents how much your interest rate will be over and above the index. For example, if your index is 3% with a 3% margin, the rate would be 3% + 3% or 6%. Following is the formula.

Index + Margin = Fully Indexed rate

Using the formulas, if the index rose to 4%, the fully indexed rate would be 7%. There is a limit on how much your loan can change: It's called a rate cap. Rate caps limit how much interest the lender can charge you.

There are two main kinds of caps typically used on ARMs:

  • A periodic cap limits how much your rate is allowed to increase from one adjustment period to the next.
  • A lifetime cap limits how much the interest rate can change over the entire life of the loan. By law, there must be an overall (lifetime) cap on adjustable rate mortgages.

Note that if the interest rate on a given loan is held down by means of a periodic cap, if the index were to go up, the lender may be able to impose the increase at the end of the next adjustment period. For example, if a periodic cap is 2% but the index rose 3%, the lender may raise the rate 2% during the present adjustment period and the extra 1% during the subsequent period.

There is a third cap called a payment cap that limits how much your monthly payment can go up at the end of each adjustment period. Usually if your ARM has a periodic rate cap, it will not have a payment cap.

The reason it's so important to consider all these caps when evaluating a loan is to understand the way that your monthly payment will increase. This is important because it will directly affect the amount of money you have on hand each month for non-housing expenses. The incremental increases in the index and rates can be deceptive. But do the math: If your monthly payment increases from $953 to $1395 over the first seven years of the loan, that is nearly a 50% increase and could represent a significant burden to your monthly budget.

If you still aren't sure about your ARM program, get a written disclosure from your lender. If you are considering an ARM, be sure to compare the annual percentage rates (APR) and caps on several ARMs to evaluate which one will cost you less money.

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