Adjustable-rate
mortgages (ARMs) differ from fixed-rate mortgages
in that the interest rate and monthly payment can
change over the life of the loan. ARMs also generally
have lower introductory interest rates vs. fixed-rate
mortgages. Before deciding on an ARM, key factors
to consider include how long you plan to own the property,
and how frequently your monthly payment may change.
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Why choose an adjustable-rate mortgage?
The low initial interest rates offered by ARMs make
them attractive during periods when interest rates
are high, or when homeowners only plan to stay in
their home for a relatively short period. Similarly,
homebuyers may find it easier to qualify for an ARM
than a traditional loan. However, ARMs are not for
everyone. If you plan to stay in your home long-term
or are hesitant about having loan payments that shift
from year-to-year, then you may prefer the stability
of a fixed-rate mortagage.
Components of adjustable-rate mortgages
Adjustable-rate mortgages have three primary components:
an index, margin, and calculated interest rate.
Index
The interest rate for an ARM is based on an index that measures
the lender's ability to borrow money. While the specific
index used may vary depending on the lender, some
common indexes include U.S. Treasury Bills and the
Federal Housing Finance Board's Contract Mortgage
Rate. One thing all indexes have in common, however,
is that they cannot be controlled by the lender.
Margin
The margin (also called the "spread") is a percentage added to
the index in order to cover the lender's administrative
costs and profit. Though the index may rise and fall
over time, the margin usually remains constant over
the life of the loan.
Calculated interest rate
By adding the index and margin together, you
arrive at the calculated interest rate, which is the
rate the homeowner pays. It is also the rate to which
any future rate adjustments will apply (rather than
the "teaser rate," explained below).
Adjustment periods and teaser rates
Because the interest rate for an ARM may change due
to economic conditions, a key feature to ask your
lender about is the adjustment period--or how often
your interest rate may change. Many ARMS have one-year
adjustment periods, which means the interest rate
and monthly payment is recalculated (based on the
index) every year. Depending on the lender, longer
adjustment periods are also available.
An ARM can also have an initial adjustment period
based on a "teaser rate," which is an artificially
low introductory interest rate offered by a lender
to attract homebuyers. Usually, teaser rates are good
for 6 months or a year, at which point the loan reverts
back to the calculated interest rate. Remember, too,
that most lender will not use the teaser rate to qualify
you for the loan, but instead use a 7.5% interest
rate (or calculated interest rate if it is lower).
Rate caps
To protect homebuyers from dramatic rises in the interest
rate, most ARMs have "caps" that govern how much the
interest rate may rise between adjustment periods,
as well as how much the rate may rise (or fall) over
the life of the loan. For example, an ARM may be said
to have a 2% periodic cap, and a 6% lifetime cap.
This means that the rate can rise no more than 2%
during an adjustment period, and no more than 6% over
the life of the loan. The lifetime cap almost always
applies to the calculated interest rate and not the
introductory teaser rate.
Payment caps and negative amortization
Some ARMs also have payment caps. These differ from
rate caps by placing a ceiling on how much your payment
may rise during an adjustment period. While this may
sound like a good thing, it can sometimes lead to
real trouble.
For example, if the interest rate rises during an
adjustment period, the additional interest due on
the loan payment may exceed the amount allowed by
the payment cap--leading to negative amortization.
This means the balance due on the loan is actually
growing, even though the homeowner is still making
the minimum monthly payment. Many lenders limit the
amount of negative amortization that may occur before
the loan must be restructured, but it's always wise
to speak with your lender about payment caps and how
negative amortization will be handled.
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