adjustable rate mortgages: understanding the terms

Adjustable Rate Mortgages:Understanding the Terms

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The interest rate on an adjustable rate mortgagethat you are quoted when shopping for amortgage can be enticing because it is oftenlower than the fixed rate that you could get onyour mortgage. What many people do not realizeis how much that interest rate will change overthe life of the loan. Before you jump at a low ARMrate, educate yourself on all of the terms thatcoincide with this loan to ensure that it is a goodfit for you.



What is an Adjustable Rate Mortgage?

An adjustable rate mortgage, or ARM, is a mortgage thatcarries an ever changing interest rate. The interest rate will befixed for the first 3, 5 or 7 years, but then will adjust after that.The adjustment period is typically annual, which means thatyour interest rate and subsequent mortgage payment willchange once per year after the initial period. There is a cap ormaximum interest rate noted in your loan agreement whichwas signed at closing, but that rate is typically much higherthan the original rate. It is important to note that the interestrate changes only affect the portion of your loan that is leftoutstanding, which can help to offset the changes in yourpayment should the interest rates increase during yourchange.



The Terms of an ARM

When your interest rate adjusts, there are various terms thatyou will need to be familiar with to understand how yourmortgage payments are affected:

Index – Every ARM has an economic indicator that isused to set its rate. The most common indicators include11th District Cost of Funds Index (COFI) and the 12-monthMoving Treasury Average (MAT). Each of theseindicators can increase or decrease at any given time.



Margin – The margin is the amount of points that areadded to the index that your rate is based upon. Thisnumber is typically based on your credit – better creditscores get a lower margin while lower credit scores geta higher margin.

Adjustment Period – Your ARM loan might come acrosslooking something like this on your loan papers – 5/1.The top number in the fraction is the number of yearsthat your loan is fixed. This is the time that you will paythe quoted interest rate upon obtaining the loan. Thebottom number in the fraction represents the adjustmentperiod of the loan, which in this case would be once peryear.



The Caps

An adjustable rate mortgage also comes with a variety ofcaps, or limits that the interest rate can change to at anygiven point. You will likely hear the terms initial cap, periodiccap and lifetime cap when applying for an ARM.

Initial Cap –Some loans have an initial cap, whichallows you to have a maximum amount that the firstinterest rate change can undergo. This is in anattempt to protect you from a shocking change inyour mortgage payment during the initial changeperiod.



Periodic Cap – Every loan has a periodic cap, eventhose that have an initial cap. The periodic cap puts alimit on the amount that an interest rate can changeduring any change period, not just the initial period.

Lifetime Cap – This is an overall limit on the interestrate for your ARM. This cap covers the loan over its lifeand is the highest that your interest rate can everreach, allowing you to plan for the worst case scenario,so to speak.



The ARM can be a very beneficial loan, especiallyduring times when fixed rate loans are on the rise. Ifyou are a risk taker or only plan to stay in your homefor a few years, an ARM can make sense. It is a greatway to save money during the first few years of yourmortgage and then decide what to do after that. Ifyou are selling the home before the fixed period isover, you do not have to worry about what willhappen to the rate. If you are staying, however, youwill need to decide if you should refinance into afixed rate or ride out the interest rate change periods.



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Justin McHood is Americas MortgageCommentator and has been providing

Mortgage commentary for over 10 years.

INFORMATION PROVIDED BY: JUSTIN MCHOOD

MORTGAGE COMMENTATOR

Information Originally Published: January 29, 2015 BLOWNMORTGAGE.COM LENDER HOTLINE: 888-581-5008

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adjustable rate mortgages: understanding the terms

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