What is an Adjustable Rate Mortgage (ARM)?
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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