Adjustable rate mortgages, commonly referred to as ARMs, are loans with variable interest rates. Unlike fixed rate loans, the interest rate of an adjustable rate mortgage may increase or decrease over the term of the loan. Interest rate fluctuations with this type of loan are linked to an economic index. These fluctuations will cause the borrower's payments to either increase or decrease accordingly. There are some inherent risks associated with ARMs, but borrowers can reduce the risk associated with ARMs by better understanding these types of loans. While ARMs will not be suitable for every situation, there are circumstances in which ARMs may be more beneficial than other traditional types of lending. By considering questions such as whether one has enough income to cover higher payments, how long one plans to live in the home, and whether or not the loan will payed off early can help borrowers determine if an ARM will be right for them.
Basic Features of ARMs
While an adjustable rate mortgage will have a variable interest rate, the initial rate and payment of the ARM will remain in effect for a specified period of time. This period of time may range from 1 month to 5 years, possibly longer. When the loan adjusts at the end of this period, the rate and payment could be significantly more than the initial rate and payment or it could remain relatively stable. Borrowers can determine if the rate will increase substantially by inquiring about the loan's annual percentage rate (APR). If the APR is greater than the initial rate quoted by the lender, the borrower can expect for their rate and payment to increase considerably when the loan adjusts. The time in which the interest rate and monthly payment change, referred to as the adjustment period of the loan, occurs monthly, quarterly, yearly, every 3 years, or every 5 years.
How Interest Rates are Determined
The interest rate of ARMs is comprised of the index and the margin. Adjustable rate mortgages are linked with specific indexes, and these indexes are what lenders use to measure changes in interest rates. Indexes that are commonly used by lenders include things such as one to five year Treasury securities. Determining the indexes used and how these indexes have fluctuated in the past can help borrowers decide if an ARM will meet their needs. The margin is essentially the interest rate that represents the lender's cost. The margin will be added to the index rate to determine the total interest rate. Margins may differ from lender to lender, but this rate will usually remain constant over the life of the loan. In some cases, lenders will base the amount of margin they add to the overall interest rate on the borrower's credit history.
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