Adjustable Rate Mortgages versus Fixed Rate Mortgages
Adjustable-rate mortgages (ARMs) differ from fixed-rate mortgages in that
the interest rate and monthly payment can change over the life of the loan. ARMs also
generally have lower introductory interest rates vs. fixed-rate mortgages. Before deciding
on an ARM, key factors to consider include how long you plan to own the property, and how
frequently your monthly payment may change.
Why choose an adjustable-rate mortgage?
The low initial interest rates offered by ARMs make them attractive during periods when
interest rates are high, or when homeowners only plan to stay in their home for a
relatively short period. Similarly, homebuyers may find it easier to qualify for an ARM
than a traditional loan. However, ARMs are not for everyone. If you plan to stay in your
home long-term or are hesitant about having loan payments that shift from year-to-year,
then you may prefer the stability of a fixed-rate mortagage.
Components of adjustable-rate mortgages
Adjustable-rate mortgages have three primary components: an index, margin, and calculated
interest rate.
Index
The interest rate for an ARM is based on an index that measures the lender's ability to
borrow money. While the specific index used may vary depending on the lender, some common
indexes include U.S. Treasury Bills and the Federal Housing Finance Board's Contract
Mortgage Rate. One thing all indexes have in common, however, is that they cannot be
controlled by the lender.
Margin
The margin (also called the "spread") is a percentage added to the index in
order to cover the lender's administrative costs and profit. Though the index may rise and
fall over time, the margin usually remains constant over the life of the loan.
Calculated interest rate
By adding the index and margin together, you arrive at the calculated interest rate, which
is the rate the homeowner pays. It is also the rate to which any future rate adjustments
will apply (rather than the "teaser rate," explained below).
Adjustment periods and teaser rates
Because the interest rate for an ARM may change due to economic conditions, a key feature
to ask your lender about is the adjustment period--or how often your interest rate may
change. Many ARMS have one-year adjustment periods, which means the interest rate and
monthly payment is recalculated (based on the index) every year. Depending on the lender,
longer adjustment periods are also available.
An ARM can also have an initial adjustment period based on a "teaser rate,"
which is an artificially low introductory interest rate offered by a lender to attract
homebuyers. Usually, teaser rates are good for 6 months or a year, at which point the loan
reverts back to the calculated interest rate. Remember, too, that most lender will not use
the teaser rate to qualify you for the loan, but instead use a 7.5% interest rate (or
calculated interest rate if it is lower).
Rate caps
To protect homebuyers from dramatic rises in the interest rate, most ARMs have
"caps" that govern how much the interest rate may rise between adjustment
periods, as well as how much the rate may rise (or fall) over the life of the loan. For
example, an ARM may be said to have a 2% periodic cap, and a 6% lifetime cap. This means
that the rate can rise no more than 2% during an adjustment period, and no more than 6%
over the life of the loan. The lifetime cap almost always applies to the calculated
interest rate and not the introductory teaser rate.
Payment caps and negative amortization
Some ARMs also have payment caps. These differ from rate caps by placing a ceiling on how
much your payment may rise during an adjustment period. While this may sound like a good
thing, it can sometimes lead to real trouble.
For example, if the interest rate rises during an adjustment period, the additional
interest due on the loan payment may exceed the amount allowed by the payment cap--leading
to negative amortization. This means the balance due on the loan is actually growing, even
though the homeowner is still making the minimum monthly payment. Many lenders limit the
amount of negative amortization that may occur before the loan must be restructured, but
it's always wise to speak with your lender about payment caps and how negative
amortization will be handled.
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