When it comes to buying a home, borrowers have mortgage loan choices that can help them match their specific financial situation to a loan type. An Adjustable Rate Mortgage (ARM) is one mortgage loan choice for the borrower interested in flexibility and a lower initial interest rate and monthly payments. The interest rate and payments stay the same during a certain period of time, typically one to five years (or possibly more) and then adjust after the initial time period based on market conditions and the individual lenders’ margin spread.
ARMs are readily available through a myriad of quality lenders throughout the country. The qualification process for an ARM is similar to what borrowers would expect with any loan. A solid credit score, strong asset management and a secure income are typically taken into consideration.
Adjustable versus Fixed Rate
Understanding the difference between a fixed and adjustable rate mortgage can help borrowers decide which loan is the best fit:
Fixed Rate Mortgage
Fixed Rate Mortgage is when the borrower locks in a certain rate, meaning that rates and payments remain stable, allowing the borrower to budget and make financial forecasts.
Adjustable Rate Mortgage - ARMs
Adjustable Rate Mortgage is basically lower payments and terms during the initial period of the loan allow the borrower to take advantage of lower rates without having to refinance. After the initial period, rates and payments fluctuate and can rise (or lower) significantly based on market conditions.
The Basic Components of an Adjustable Rate Mortgage
Several components impact how and when the rate adjusts on an ARM.
This rate adjustment also impacts the amount of money the borrower pays for his or her mortgage each month. Even if the interest rates remain stable, the borrower’s payments may fluctuate due to a few factors:
ARM adjustment: ARMs are based on an adjustment period, typically every month, quarter, or for three or five years. The time between rate changes is the adjustment. For example, a loan with a three year adjustment period would be a 3-year ARM.
The index: This is an average of national interest rates. When the index rises, so does the borrower’s monthly payments. However, when the index drops, the borrower’s payments follow suit. Lenders base ARM rates on indexes such as -year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR).
The margin: Individual lenders may add a few percentage points to set the interest rate on the ARM. This is called the margin. Margins differ from lender to lender, but borrowers can rest assured the margin is typically the same over the life of the loan. How lenders determine the margin may differ—some assign a lower margin to borrowers with an exceptional credit rating whereas other lenders just offer a fully indexed rate which is equal to the margin plus the index.
Interest rate caps: An interest rate cap is a limit to how high the rate can increase during the life of the loan. There are two types of caps—periodic and lifetime. A periodic cap limits the amount the rate can adjust either up or down after the initial adjustment. A lifetime cap is a limit on how high the interest rate can climb through the life of the loan. By law, all ARMs have a lifetime cap.
Payment caps: Like interest rate caps, ARMs also have a cap on how much the borrower’s payment can increase for each adjustment. For example, if the loan has a payment cap of 5%, payments won’t increase more than 5% of the previous monthly payment. Payment caps can also add to the amount owed on the loan if the amount of interest owed isn’t paid because of the payment cap.
Adjustable Rate Mortgage Types
Like many mortgage products, one size doesn’t fit all. ARMs come in a variety of types to accommodate several kinds of borrowers:
Hybrid ARM loan is a mix of an adjustable and fixed rate mortgage. These loans are typically presented as 3/1, 5/1, 7/1 or 10/1 loans. The interest rate is fixed for the first period of the loan (for example three years on a 3/1 or five years on a 5/1). Following the initial period the rate adjusts until the loan is paid off. For example, a 7/1 loan, the rate remains stable for seven years then adjusts for one.
Interest Only ARMs
With Interest Only ARMs the borrower pays only the loan’s interest for a certain period of time, which allows for lower payments during that time period. After the initial period the payments increase even if the rate is stable because the borrower must pay back principal in addition to the interest.
Payment Option ARMs
Payment Option ARMs is when borrowers can choose among a smorgasbord of options each month including making traditional payments of principal and interest, interest only or make a limited or minimum payment. This ARM type has a built in recalculation period, typically every five years based on the remaining term of the loan. How the borrower determines each monthly payment is taken into consideration with recalculation.
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