Mortgage Consultants Group

Adjustable Rate Mortgage

The structure of an Adjustable Rate Mortgage (ARM) is more complex than a Fixed Rate Mortgage (FRM).  After an initial period (ie 3, 5, 7 years) during which the rate is fixed and the principal and interest payments stay the same, this type of loan has periodic times when the interest rate and payment are adjusted, typically every 12 months. Usually, ARMs offer lower initial interest rates than a Fixed Rate mortgage, but there is a risk of higher payments in the future when the index (see below) changes.

ARMs have an adjusting time period built into the loan such as one month, one quarter, one year, three years, or five years.  A 1-year ARM would adjust every year, whereas a 3-year ARM would adjust every three years.  When the loan is adjusted at each adjusting period, the loan payment will likely change—often for the worse.  However, there are some limits built into the system to help protect the borrower (see caps below). 

Besides the adjustable characteristic of an ARM, the interest itself is more complex.  There are two levels of determining factors that affect how the ARM interest is adjusted.  First, the ARM is tied to an index which measures interest fluctuations over time.  Second, there is an interest margin that the lender adds on to the index amount.  This margin generally stays constant through the life of the loan, but the index changes according to the particular index used.  Make sure you know both which index is being used and what the interest margin is when you choose an ARM.  Find out how stable the index has been over the past years.  You may have to find an ARM with a more secure history.

The specific index will determine:

  • the interest rate adjustment
  • the maximum size of interest adjustment that can be made each adjusting period
  • the maximum interest rate that can be given for that loan
  • and any caps on payment amount

The cap placed on the size of the interest rate adjustment will determine how quickly your loan will jump to the maximum amount.  While these caps offer some security, there are some pitfalls!  Sometimes, the adjustment happens too quickly, causing the payments to rise dramatically.  Also, caps placed on the payment amount may result in a payment that won't cover the interest.  The deferred interest adds to your loan.  You pay more interest as a result.  Your loan is now into a negative amortization.  You might think you are paying down your loan, but instead, your loan is actually growing.

Payments can also jump higher when an initial discount rate expires (especially if it is at the same time that a scheduled adjustment happens).  Sellers or home builders will pay these buydown fees as an incentive or to help get terms that work for a buyer.  Once again, there are pitfalls!  Often the price of the house is raised by the amount of the fee, which in the long run, may negate the initial benefits. Also, the payment may jump so high that the home owner simply can't make the payment. 

There are other features that can be incorporated creating a variety of types of ARMs such as interest-only ARMs, payment-option ARMs, or a hybrid loan. Because of the complexity of adjustable rate mortgages, the buyer must be very careful in choosing the right ARM.  Don't be afraid to ask your lender specific questions.

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