An ARM is a mortgage with an interest rate that is linked to an economic
index. The interest rate--and your payments--are periodically adjusted
up or down as the index fluctuates.
You'll hear the following terminology when talking with lenders about
ARMs.
Index
An index is what the lender uses to measure interest rate changes.
Common indexes used by lenders include one, three, and five-year
Treasury securities, but there are many others. Each ARM is linked
to a specific index.
Margin
Think of the margin as the lender's markup. It is an interest rate
that represents their cost of doing business plus the profit they
will make on the loan. The margin is added to the index rate to
determine your total interest rate. It usually stays the same during
the life of the loan.
Adjustment period
The adjustment period is the period between rate adjustments.
You may see an ARM described with figures such as 1-1, 3-1, and
5-1. The first figure in each set refers to the initial period of
the loan, during which your interest rate will be the same as it
was on the day of closing. The second number is the adjustment period,
showing how often adjustments can be made to the rate after the
initial period has ended. The examples above are all ARMs with annual
adjustments.
If my payments can go up, why should I consider an ARM?
The initial interest rate for an ARM is lower than that of a fixed
rate mortgage (where the interest rate remains the same during the
life of the loan). A lower rate means lower payments, which might
help you qualify for a larger loan.
Other reasons to consider an ARM:
The possibility of higher rates isn't as much of a factor if you
plan to be in the home for a relatively short time.
Do you expect your income to increase? If so, the extra funds may
cover the higher payments that result from rate increases.
Some ARMs can be converted to a fixed-rate mortgage. However, conversion
fees may be high enough to take away all of the savings you saw
with the initial lower rate.
While you normally can't dictate which index a lender uses, you
can choose a lender based on which index will apply to your loan.
Ask how each index has performed in the past. Your goal is to find
one that has remained fairly stable in economic downturns.
When comparing lenders, consider both the index and the margin
rate being offered.
If the lender doesn't plan to sell your loan on the secondary market,
you might be able to avoid the Private Mortgage Insurance (PMI)
that's normally required when a buyer makes less than a 20% downpayment.
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