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Mortgage Guide: Adjustable Rate Mortgage Loans Explained

How Adjustable Rate Mortgage Loans Work

Arm Mortgages Explained

By Staff

Fixed rate and adjustable rate mortgage loans are both used to purchase a home or refinance an existing mortgage, but their terms are quite different. Fixed rate mortgage loan terms are fairly straightforward; ARM loan terms are anything but. This guide explains how adjustable rate mortgages work, describes the benefits and risks of ARM loans, and outlines how to determine if an adjustable rate mortgage is right for you.

Where a fixed rate mortgage loan has a set interest rate and payment throughout its typical 15- or 30-year term, an adjustable rate mortgage loan's rate and payment readjust periodically -- as often as monthly -- after an initial fixed period, though they do carry maximum interest-rate "caps." Because the rate resets to reflect current market rates, lenders usually charge a slightly lower initial interest rate for ARMs than fixed rate mortgage loans.

That lower initial rate can enable borrowers to qualify for a larger loan and more expensive house. Yet adjustable rate mortgages also expose them to potentially sharp hikes in interest rates that could nearly double their monthly payment in a few years' time. For example, a $300,000 ARM with a 6% interest rate and $1,799 monthly payment could rise to a maximum 12% rate and $3,071 payment in three years. Many Americans who've lost homes to foreclosure were "sub-prime" borrowers with weak credit records who took out exotic ARM loans with steep payment adjustments they could not handle.

Adjustable Rate Mortgage Loan Terms Demystified

An adjustable rate mortgage loan's initial fixed-rate period can remain in effect anywhere from one month to 10 years. The shorter the period, the lower the initial interest rate will be compared with the standard fixed-rate mortgage loan. Keep in mind that your rates and payments can change considerably after the initial period even if interest rates remain stable, based on formula used. For that reason, when shopping for an ARM, inquire about the annual percentage rate (APR). If it's appreciably more than the initial rate, you will likely face a jump in your rate and payments even if interest rates remain stable over that time.

An adjustable rate mortgage loan's adjustment period is the period between rate changes. A one-year ARM, for example, readjusts from its fixed initial rate to the variable rate at the end of the first year. Likewise, three-year, five-year and seven-year ARMs retain a fixed rate for those periods and then readjust. Once the variable rate comes into play, the home loan typically readjusts on an annual basis thereafter.

The adjustable rate mortgage loan's interest rate is based on an index, plus an added "margin" charged by the lender. The most common indexes employed are the Cost of Funds Index (COFI), the London Interbank Offered Rate (LIBOR) and the one-year Treasury Bill.

Find out what index a prospective lender uses and ask for a long-term history of its movements to get a clearer sense of its potential volatility and shifts over time. You can track movements in the most frequently used indexes in major newspapers and on the Internet to prepare for any change in payment come your ARM loan's readjustment date.

The caps, or limits, on rate increases and reductions generally run 2% tops at each adjustment period and a maximum of 6% from the initial interest rate. The former is called a periodic adjustment cap and the latter, a lifetime cap that all adjustable rate mortgages loans must have by law.

The periodic caps protect the borrower from sudden severe hikes in interest rates. For example, that $1,799 monthly payment on the $300,000 adjustable rate mortgage loan initiated at a 6% interest rate would jump to $2,400 in one year's time if the underlying interest rate rose to 9%. The typical 2% annual cap would limit that rate hike to 8% -- and the payment increase to $2,192. If interest rates rose 3% more to 12% in the following year, the 2% cap would again limit the upward adjustment to 10%.

Bear in mind, that a 2% drop in interest rates in year three won't lower your adjustable rate mortgage loan monthly payment because your capped rate would now be equivalent to the present market rate. And if the underlying rate remained at 12% at the end of three years, your rate could still rise again up to your lifetime cap.

Some adjustable rate mortgage loans offer payment caps, which limit the amount your payment can go up at the adjustment period. With a 10% payment cap, the $1,799 initial payment on that $300,000 loan could only rise to $1,979 max. But borrowers still are on the hook for the increased interest fees they'd owe within their rate cap, which are added to the balance of the ARM loan, resulting in what's called negative amortization.

Some lenders offer what are called "convertible ARMs" where the borrower can change from an adjustable rate mortgage loan to a fixed rate loan at certain times during the term. Upfront costs and the initial interest rate may be slightly higher for a convertible adjustable rate mortgage loan, which also may charge a fee for the conversion.

How to Know If an Adjustable Rate Mortgage Loan Is Right for You

To determine if a fixed or adjustable rate mortgage loan makes sense for you requires understanding such factors as indexes, margins, discounts and caps on rates and payments. Most important is to know what your maximum monthly payment can be. Bear in mind that if you opt for the greater certainty of a fixed rate mortgage and rates fall sharply, you can always look to refinance that loan at a lower fixed rate.

The Federal Reserve Board recommends asking these questions of yourself before taking out an adjustable rate mortgage rather than a fixed rate mortgage:

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