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Adjustable Rate Mortgages (ARMs)

What is an Adjustable Rate Mortgage (ARM)

An adjustable rate mortgage, also known as an ARM, is a mortgage where the interest rate is periodically adjusted based on an index such as the Prime Interest Rate. These mortgages typically carry a lower initial mortgage payment. However, the potential exists for monthly payments to rise should interest rates increase, making ARMs a wise choice for those whose income may go up over the life of the loan, or those who plan on moving within the next few years.

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Also known as variable rate mortgages, theThe idea behind ARMs is to ensure a steady margin for the lender, whose own cost of funding will usually be related to the same index. Adjustable rate mortgages, also known as variable rate mortgages, differ from graduated payment mortgages, which offer changing payment amounts but a fixed interest rate. The main characteristics of adjustable mortgage rates are the index and limitations on charges, also known as caps.

The main characteristics of adjustable mortgage rates are the index and limitations on charges, also known as caps.

The four components of ARMs are:

The two types of caps—annual and life-of-the-loan—protect the borrower from large interest rate swings. While the annual cap restricts the amount that the interest rate can change in any given year, the life-of-the-loan cap limits the maximum (and minimum) interest rate the borrower can pay for as long as he has the mortgage.

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How do ARMs Work?

The function of adjustable rate mortgage or ARM is briefly defined below:

Initial rate and payment - The initial rate and payment amount on an ARM remains in effect for a limited period, which can range from as little as one month to 5 years or more. In some cases, the initial rate and payment vary considerably from the rates and payments later in the loan term. It should be noted that even if interest rates are stable, the rates and payments could change significantly.

The adjustment period - With most ARMs, the interest rate and monthly payment change on a regular schedule: by the month, quarter, year, or every 3 or 5 years. This period between rate changes is called the adjustment period. So, for a loan where the interest rate and payment can change once a year, the adjustment period is one year, and the loan is called a one-year ARM.

The index - The index and the margin are two components on which the interest rate of an ARM is based. While the index is a measure of interest rates, the margin is an extra amount that the lender adds. A rise in the index rate is associated with a similar rise in the interest rate in most circumstances, resulting in higher monthly payments.

In addition to these, a few lenders use their own cost of funds as an index.

The margin - Lenders add a few percentage points to the index rate, called the margin, to determine the interest rate on an ARM. While the amount of the margin may differ from one lender to another, it is usually constant over the life of the loan. The fully indexed rate is equal to the sum of margin and the index, and if the initial rate on the loan is less than the fully indexed rate, it is called a discounted index rate.

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Interest-rate caps - An interest rate cap limits the amount the interest rate can increase and generally comes in two versions:

Payment caps - Many ARMs place a limit on the amount that the monthly payment may increase at the time of each adjustment. This is the payment cap.

Make sure that you are familiar with negative amortization should your ARM include a payment cap. Negative amortization occurs when your monthly payments are not sufficient enough to pay the interest on your loan. This may actually lead to your loan balance increasing.

What are the Advantages of Adjustable Rate Mortgages?

An ARM can allow you to:

In addition, an ARM may offer you payment options that allow you to take control of your finances. These may include monthly payment options based on mininum payment, interest, full principal or interest only.

The adjustable rates of an ARM shift a portion of the interest rate risk from the lender to the borrower, and are usually used where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate falls, and loses if interest rates rise.

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