Is an ARM Loan Right for You
Your mortgage loan provider should be able to outline all possible mortgage loan options available to you and you family. As a borrower, it is important for you to have the information you need in order to weigh the benefits against the possible risk unique to each loan program. One type of loan for you to consider is an ARM loan.
How is an ARM loan different from a Fixed Rate loan?
ARM stands for Adjustable Rate Mortgage. The interest rate used to figure the payment adjusts according to a specific financial index. Therefore, your loan payment may increase or decrease after the loan is closed. An ARM is often more attractive than other loan offerings due to an initial lower interest rate and payment amount.
In addition, some lenders offer home loans that allow you to (1) pay only the interest on the loan during the first few years of the loan term (Interest-Only mortgage) or (2) make only a specified minimum payment that could be less than the monthly interest on the loan (payment-Option ARM).
By contrast, a fixed rate loan has an interest rate that remains constant throughout the term of the loan. With any loan, make sure you talk with your loan provider and fully understand the loan terms and the risks you face.
How is an ARM interest rate determined? Interest rates on ARM loans are usually based on an index with the addition of a margin.
Indexes
An ARM typically relates interest rates to general economic conditions at any given time. Interest rates most accutately reflect the mortgage lender's cost of funds. As the interest index rises and falls, reacting to the economy, the lender's costs mirror the index requiring that ARM rates change as well. Some examples of ARM indexes include the Wall Street Journal Prime Rate and the average yields on U.S. Treasury Securities.
You will find some ARM loans which are adjusted by the lender to reflect market conditions rather than indexes. Generaly, their rates are comparable to loans tied to an index. Competition keeps them from getting out of line.
Margins
The margin is a pre-determined amount that is added to (or, in some cases, subtracted from) an index value to arrive at the interest rate. For example:
Index at 5.50% + Margin at 2.50% = 8.00% Interest Rate
Using the formula in this example, if the index value fell to 5.25% at your next interest rate adjustment, the interest rate on your ARM may fall in your favor to 7.75%. Often the interest rate is subject to rounding, a pre-set increment adjustment. For example, the interest rate may round to the nearest one-eighth of one percent (0.125%). Therefore, if the index were 5.48, it would become 5.50%
How are adjustments controlled?
Life Caps
Because our economy is volatile, ARM loans can be subject to significant interest rate changes over the life of the loan. As a result, the Truth-in-Lending law requires a life cap - the maximum rate of interest that can be charged for a particular ARM loan - be clearly identified to the borrower. This life cap is determined when the loan is made and is expressed either as a predetermined maximum rate of interest or as the maximum amount of charge over the intial interest rate.
Using the example above, an initial ARM interest rate of 8.00% can have a life cap expressed as a maximum rate (as an example 12.00%) or a maximum percentage change (as an example of a 5.00% maximum change, 8.00% initial interest rate + 5.00% = 13.00% cap).
Adjustment Caps
In addition to life caps, some ARM loans may have an adjustment cap. This is a limit on the amount the loan interest rate can change at any one time (the frequency of the adjustment period is determined when the loan is made, but typically there is an annual adjustment).
A common adjustment cap is 2.00%, although a different percentage may be specified. Using our example of an initial 8.00% mortgage rate, with a 2% cap, the first interest rate adjustment could go no higher than 10.00%, or no lower than 6.00% even if the index were to change more than 2.00% during the adjustment period. The second and subsequent adjustment(s) will be subject to the 2.00% cap, but now use the interest rate of the last adjustment period. The purpose of an adjustment cap is to minimize the financial impact of index changes to a loan in any one period.
Payment Caps
An alternative to an adjustment cap is a payment cap. This is a limit on the amount or percentage that a payment may change at each adjustment. If this cap was 7.50% and your monthly payment was $800.00, the most your payment could increase would be $60.00 - to $860.00. At the next adjustment, the most your payment could increase would be $64.50 (7.50% of $860.00 - for a $924.50 payment this period).
Note: If your loan has a payment cap, check for the potential of negative amortization. This occurs when the interest index has increased faster than your payment's ability to absorb all of the interest now accuring on your mortgage. This excess interest not paid is added back to the principal and you end up owing more at the end of the loan.
A Final Comparison
Because there are so many different ARM programs, we strongly recommend you allow your mortgage broker to explain them to you in more detail. In a final note, a ARM loan can offer several advantages to the borrower.
- A lower initial interest rate as compared to a fixed rate loan
- A lower initial monthly payment
- Lower overall mortgage cost if you believe interest rates will remain the same or decrease over the life of your loan
The flip side is its obvious disadvantages; an unstable economy could cause interest rates to increase, and you would pay more for your loan
Federal law entitles you to a detailed disclosure of any ARM program. Armed with this information and the counsel of your loan officer, you will be able to determine the potential course of an ARM loan over its life and make an informed decision if an adjustable rate mortgage is right for you.
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