Adjustable Rate Mortgages Made Simpler

An ARM or adjustable rate mortgage is often sought by homebuyers over fixed rate loans. Understanding ARM can be quite difficult, particularly for first time homebuyers. ARM mortgage has variable interest rates. Here the interest rate and your loan payments can change periodically in accordance with the economic index. The economic index refers to a standard followed by lenders. There are many sub-divisions within the economic index. Each lender follows a particular index. When you are shopping for home loans, compare the indexes used by different lenders. Try to identify an index that has remained largely stable in the recent past.

You will certainly come across many more terms when exploring adjustable rate mortgages. To make this easier for you, we are explaining some more terms that will help you understand and compare ARMs.

Adjustment Period

The period between two interest rate adjustments is called the adjustment period. ARMs are often compared on the basis of adjustment periods. This is usually mentioned in the form of single digit numbers separated by hyphens. Here, the initial period of the loan is mentioned. This is the fixed-rate period. The rate that was offered to you on the day you were granted the loan is applicable here. This is followed by the adjustment period. This follows the initial period, during which the rate can be altered by the lender. Most ARMs have annual adjustments.

Margin

This is the mark-up added by the lender. It includes the lender’s profit and the overall cost of doing business. The margin directly impacts the interest rate offered to the borrower. The sum of the margin and index rate is the total interest rate, i.e. the rate offered by the lender to you.

Amortization

Amortization is usually seen in larger payments. Here the lender pays the monthly interest and a part of the principal amount. However, negative amortization presents a problem. If you are not able to pay the interest amount, the unpaid sum is added to your total loan. Thus, your future interest payments are further raised.

Importance of Interest Rate Caps

Caps or limitations have been created to ensure that interest rates aren’t hiked beyond a reasonable limit. Periodic rate caps present the limit to which your interest rate can be hiked between two adjustment periods. Please note that all ARMs might not offer such caps. The overall cap defines the extent to which the interest rate can be raised through the total period of a loan. It is best to check the rate cap before going for an ARM.

Importance of Payment Caps

Since ARMs expose the borrower to changing monthly payments, regulations have been put in place to ensure that payments aren’t increased beyond a limit. Some ARMs have payment caps and don’t offer periodic rate caps.

Importance of Carryovers

With interest rate caps in place, lenders need a tool to spread the total, intended hike across the future adjustment period. This is called a carryover. You need to talk to your agent to understand things better.