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| Adjustable Rate Loans |
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An "ARM", or "Adjustable Rate Mortgage" has a fluctuating interest rate and the potential for changing payment amounts. In most ARM mortgages, the interest rate on a loan is fixed for a certain number of years and then allowed to fluctuate in sync with current economic factors.
An ARM is of value to the lender because the risks of lending money in a changing economy are passed on to the borrower. In exchange, most lenders are able to offer a lower initial interest rate to the borrower in exchange for their assumption of this risk.
Adjustment Period
This is the predetermined period for which the rate of an ARM is adjusted. For instance, a 3/1 ARM has a fixed rate for the first three years of the loan and is then adjusted once every year through the term of the loan to reflect the current economic conditions.
Caps
This is a limit specified in the ARM loan for individual and cumulative interest rate adjustments. An example of this is a 2/6 cap, which allows the interest rate on your ARM loan to go up or down by no more than two percent every adjustment period, and has a total limit of six percent for cumulative changes. Therefore a 2/6 cap on a 5% ARM will allow a maximum rate of no more than 11%.
Index
The measurement, or basis, that lenders use to adjust the interest rate on an ARM. ARMs are usually quoted with a "teaser", or first-year rate, and then expressed as an index plus a margin. For instance, a 5/1 ARM may be advertised at 5% with a 2.5% margin over the U.S. 30-year bond index. This means that your first year's rate would be 5%. The second year, the rate would be 2.5% plus whatever the 30-year bond rate was, such as 6%, making your rate through year five equal to 8.5%. In year five, your rate is adjusted again, this time to 2.5% plus the current 30-year bond rate, now 7%, making your new rate equal to 9.5%.
Negative Amortization
This occurs when the combination of interest rates adjustments and payment caps result in a monthly payment that does not cover the interest portion of your loan. In this case, the difference would be added back to the total amount you owed on the loan, thus making a "negative amortization" to the mortgage.
Convertible Adjustable Loans
Convertible ARMs offer the borrower the option to convert the loan from an adjustable-rate to a fixed-rate at specified times during the term of the mortgage. This option is attractive to many buyers who may wish to take advantage of current low interest rates, but want the security of a fixed-rate loan in the future. Be aware of any costs associated with the conversion of the loan.
Questions to Ask When Considering an Adjustable
1. What would the rate be today if it were fully adjusted, based on the current value of the index?
2. Is there a prepayment penalty?
3. How long before the interest rate can adjust?
4. By what amount can the rate adjust at that time? Over the life of the loan? |
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