Adjustable Rate
Many borrowers want an Adjustable-Rate Mortgage (ARM) because it will initially have a lower rate than a fixed rate mortgage therefore, resulting in a lower monthly payment. An adjustable rate is great for a borrower who only intends to have the mortgage for a short period of time. The interest rate will eventually change during the life of the loan and the payment will most likely go up. Therefore, it’s crucial to your financial future for you to understand the specifics of how an adjustable-rate mortgage works. ARM’s have limits to how high the rate can go up each time the the loan adjusts. Below details what happens when an ARM adjusts.
Adjustment periods
All ARMs have adjustment periods that determine when and how often the interest rate can change. There is an initial period during which the interest rate doesn’t change – this period can range from as little as 6 months to as long as 10 years. After the initial period, most ARMs adjust the interest rate periodically.
Indexes and margins
Once the initial period is over the rate will adjust and then continue to adjust at every adjustment period, the interest rate can change based on two factors: the index and the margin. Interest rate adjustments are based on a published index. There are many indexes but some commonly used for ARMs are the London Interbank Offered Rate (LIBOR) and the U.S. Constant Maturity Treasury (CMT). Indexes reflect current financial market conditions, which is why your ARM interest rate can change at each adjustment period. The margin is the percentage that can be added to the index. Based on these two factors, the interest rate on your mortgage can increase or decrease. This will cause changes in your monthly payments. Don’t forget, if the interest rate on your mortgage increases, your monthly payment will also increase.
Caps, ceilings and floors
All ARMs have rate caps, also known as ceilings and floors. Caps decide how much the interest rate can increase or decrease at each adjustment period and over the life of your loan. For example, a 5 year ARM with a 5/2/5 cap structure means that for the first 5 years the rate is will not change, but on the sixth year (the date of first adjustment), your rate can increase by a maximum of 5 percent (the first “5″) above the initial interest rate. Every year thereafter, your rate can adjust a maximum of 2% (as noted by the second number “2″). However, your interest rate can never increase more than 5 percent (the last number, “5″) throughout the life of the loan.
