How to Understand an ARM – Adjustable Rate Mortgage

With the current economic crisis and record foreclosures, one of the mortgages taking considerable heat is the ARM or adjustable rate mortgage. But what is the ARM and how is it different than an amortized loan?

Difficulty: Moderately Easy

Instructions

1. Understand that the interest rate of an ARM will fluctuate up and down. What rate you pay at the beginning of the loan will typically change during the life of the loan.

2. Understand that the interest rate used in an ARM is tied to the fluctuation of the economic indicator or index. Most indexes are tied to the United States Treasury securities.

3. Realize that the ARM interest rate is the index’s rate plus a premium. A premium is referred to as the margin. The business’ cost of doing business is represented by the margin.

4. Identify the rate cap. An ARM has a limit in the interest that can be charged. This is called a rate cap. Typically an ARM will have two rate caps. One rate cap limits how much interest can be raised at one time, and the other rate cap limits the amount the interest can be raised during the life of the loan.

5. Identify the payment cap. The payment cap limits the amount of the monthly mortgage payments, so the borrower will be able to make that payment. Yet, if the monthly mortgage amount is not sufficient to cover the amount to cover an ARM payment with the higher interest, that amount is applied to the balance of the loan. Which means, the amount due on the property can increase over time, if the payment cap is too low.

6. Identify the adjustment period. This identifies how often the rate can be changed, such as quarterly or annually.

Resources

• About FHA Loans