"Adjustable Rate" Mortgages
An
adjustable rate mortgage or (ARM) has an interest rate that changes based
on changing market rates. This kind of mortgage usually
offers an initial interest rate that is significantly lower
than that of fixed rate mortgages, but it doesn't offer the
stability or assurance of a known mortgage payment in the years to
come. The interest rate on an adjustable rate mortgage is
adjusted periodically based on an index that reflects changes in
market interest rates. Adjustable rate mortgages have adjustment
periods that determine how frequently the interest rate can
change.
Adjustable rate
mortgages are really not as complex as many people seem to believe.
ARMs are basically broken down as follows:
Index
Margin
Adjustment Period
Rate Caps
The index is what your rate
correlates to. Most Adjustable Rate Mortgages are indexed to a
1-year T-Bill or LIBOR (London Inter-Bank Offered Rate)
and is very similar to the federal funds rate in the U.S. The LIBOR
index is released every day and it is what the banks use to lend
money to one another over the short term. LIBOR is only one of many
indexes used with ARMs. Other indexes might include 3-6 month
T-Bills, 1-6 month LIBOR ARMs, Certificates of Deposit (CD), and the
prime rate. In short, it is a daily published number used as a basis
for adjusting the interest rates on Adjustable Rate Loans.
The Margin is the difference between your loan
rate and the index. The lender will add approximately 2 - 2.75
percent to the indexed rate to arrive at the
"fully indexed rate" (index + margin). With some loan
programs and lenders, you can buy down or discount the margin for a
fee.
The Adjustment Period is the
period when your ARM can adjust its rate. When the end of your
adjustment period has come, your margin is added to the most up to
date index to get your new rate. More often than not, your rate will
not be the same and will have changed based upon the values within
the index. There are many different ARM programs that will have
varying adjustment periods. Common adjustment periods are 1 month, 6
month, and 1 year.
Here is an Example...
In the previous example, your
"fully indexed rate" was 6%
At the end of the 1 year
adjustment period, the index increases
from 4% to 5%. Your margin will remain at 2%.
Your new fully indexed rate
is (index + margin) = 7%
The question many people will ask
right away is "What happens if the index jumps to some ridiculous
number? What will happen to my rate?" Rest assured that there are
measures in place to prevent such an occurrence.
A Rate Cap is a limit on how high your
rate can change at the end of your adjustment period. The Rate cap
protects customers from high increases in their index by limiting
how much your rate can increase per adjustment period. Rate caps can
vary depending on your loan program but are typically set to about
1-2 percent per adjustment period. This means that if your rate is
currently 5% with a 2% Rate Cap, at the end of your adjustment
period, the maximum your rate can increase to is 7%.
An Adjustable rate mortgage is
attractive when rates are relatively high. If rates are at all time
lows, a
fixed rate mortgage is more attractive. If you plan on staying
in your home for a short period of time, or if you move often, than
an ARM might be financially beneficial. An Adjustable Rate Mortgage
gives you the benefit of starting off with a very low rate with a
possibility of moving into a 15 or 30 year fixed if mortgage rates
decline to all historical lows.
Call
and speak with us today and one of our Loan Professionals can
guide you toward the best loan option for your needs.
