Once thought of as the agile, exuberant cheerleader of home loans, the adjustable rate mortgage (ARM) accounted for as many as one in four mortgages in 2006. A few years later, when ARMs became branded one of the risky, greed-filled indulgences of the financial crisis, their number fell dramatically. Yet ARMs have seen a recent uptick in popularity, but with a much clearer view of what they really are and who can benefit from their flexibility.

How does an Adjustable-Rate Mortgage Work?

Adjustable Rate MortgageFirst off, an understanding of basic ARM terminology is a necessity when considering whether an ARM might be right for you. Much different from a fixed rate mortgage where interest rate, term and payments are relatively well defined and stable, the ARM can have many different options which will impact both your payment and your loan balance now and possibly for years to come.

Adjustment Period

The first term to be armed with is the adjustment period, or the length of time in which the interest rate (and probably the payment) will remain stable before it can be changed, either up or down. For example, a 1-year ARM can change once a year and 3-year ARM can change once every 3 years. Many ARMs are known as ‘hybrid’, which means that they will remain fixed for a certain longer period before changing on a more frequent basis. Hybrid ARMs are often expressed with the first number being the fixed period and second number being the frequency of change thereafter. A 3/1 ARM will remain fixed for the first three years then adjust every year thereafter. A 5/1 ARM will remain fixed for five years before adjusting every year.

Index and Margin

There are two terms that work together to determine the interest rate you pay. These are index and margin. The index is a published financial interest rate index on which your own interest rate is based. There are many different indexes which lenders may use, the most common being the CMT (1 year constant maturity treasury rate), the LIBOR (London Interbank Offered Rate) and the COFI (cost of funds index.) History and current information on any of these indexes is readily available on the internet. You should know which index your ARM would be tied to and what your starting index would be.

The margin is the percentage points your lender will add to the index to calculating your own interest rate. Margins differ from lender to lender and are often reduced for better credit scores, but they usually remain constant over the life of the mortgage. Your fully indexed rate (actual interest rate) is the sum of the index plus the margin. This will establish your beginning interest rate, and also your new rates at the times of adjustment.

Adjustable-Rate Mortgage Caps

Also important to understand are the caps of your ARM. Caps are limits and different caps may limit different things on the same mortgage. Any specific ARM can have several caps. Your lender is required to provide you information about your caps, and all other information relevant to your loan costs now and in the future.

One typical cap is the interest cap that comes in two varieties. The periodic interest cap is the maximum amount up or down your interest rate can be changed at the time of any single adjustment. This periodic interest cap can happen every time an adjustment is made. However, if the calculated adjustment is greater than the cap the difference could be added at the next adjustment. So if your ARM has a periodic interest cap, be sure to find out how it will work.

Limiting the amount your interest rate can be adjusted over the lifetime of your loan is called the lifetime interest cap. All ARMs are now required by law to have a lifetime interest cap. As well as the upward caps, you should know the downward limits of your interest rate adjustments too. Sometimes these are restricted, or not allowed at all.

A payment cap is simply what it implies – the most your payment can change as a result of any periodic adjustment during a certain period of the mortgage. A payment cap sounds like a good way to limit your risk, but a payment cap only limits your payment, not your interest adjustment. If your payment is limited to less than your interest adjustment requires, the difference can be added to your principal and you can actually end up owing more on your mortgage than you started with. This frightening condition is called negative amortization.

Exotic ARM Options

Many creative options are available that can make ARMs seem more attractive than they might really be. There is the I-O ARM, or the mortgage for which you pay interest only during the first three to ten years. There is the minimum (or limited) payment ARM which allows you to pay a fixed amount that may not even cover interest, with the unpaid interest balance added to the principal of the loan, again resulting in negative amortization. Typically these types of ARMS hold a limited recast (recalculation) period, such as five years, in which the mortgage payment is recalculated based upon current mortgage balance and interest rate adjustments. Recasting can result in a condition known as payment shock – no explanation needed for that term.

Other notable elements of ARMs to watch for are low teaser or starter interest rates that are offset by hefty closing points or unusually high rates after the initial period. If you pay for discount points or a discount fee up front, be sure to clarify the time period you will receive the discounted interest rate. Sometimes the discount expires with the first adjustment. Also take note of any prepayment penalties that may apply. These can come in two varieties – hard penalties that apply whether you sell or refinance and soft penalties that apply only if you refinance, not if you sell. And some ARMs come armed with a convenient conversion option, so that you can convert to a more predictable fixed rate mortgage if you grow tired of all the adjustments.

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