ARM Mortgages
The type of mortgage available to you when you purchase or refinance a home varies, and the choice that you make will affect how much your mortgage loan costs you. Adjustable rate mortgages, or ARMs, are one option. They work by transferring the risk of rising interest rates from the lender to the borrower.
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What is an ARM?
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An ARM is different from a fixed rate mortgage. While a fixed rate mortgage has a locked interest rate and a fixed payment, an ARM's payment is subject to change, either to increase or decrease. This is because the interest rate on the mortgage changes throughout the loan term. Other than the adjustable interest rate, the purchaser never notices much difference between an ARM and a fixed rate mortgage. The property that you purchase secures either type of loan against default.
Index and Cap
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ARMs do not have rate increases just because a banker thinks that it is a good idea. An ARM's interest rate is tied to an external index, such as a published interest rate. Your contract may say that the ARM will use the London Interbank Offered Rate, for example, which is a common index. Your contract will say that you pay the index rate, plus a margin, for your interest rate on the loan. The cap is the highest amount that your interest rate will go. For example, if your mortgage starts out at 4 percent, and it has a 6 percent cap, the most that you would spend on the interest rate would be 10 percent.
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Other ARM Options
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ARMs are available in interest-only loans, which means for a certain time period, say, 10 years, you will pay only the interest on your loan. After this, the loan would convert to an amortizing loan, or a loan that you make regular principal payments on to reduce the balance. Hybrid ARMs may be called 3/1 or 5/1 loans, which means that your loan would stay at a fixed rate for three or five years, and then could adjust by every year.
Other Considerations
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Your ARM may offer a discounted rate, which means that the initial loan interest rate is below what the index rate plus the margin. This type of loan is almost sure to change when the initial interest rate expires. Even with these changes, the discount loan can be a chance for you to save a considerable amount on his mortgage, particularly if you are going to live in the home just a short time and then sell before the real interest rate takes affect. Negative amortization is when the mortgage increases in balance because the interest rate went up, but the payment was capped. Be sure that you know if your mortgage is subject to negative amortization.
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