An adjustable rate mortgage, also referred to as ARM is a type of mortgage whose interest rate is connected to an economic index. The interest rate and consequently your payments are adjusted at regular intervals with the changes in the index. These are a few of the aspects of ARM:
• Index: It refers to a benchmark or a guide which is used by lenders to calculate interest rate fluctuations. One of the common forms of indexes that are used by the lenders includes Treasury securities activity of one, three and five years. However there are several others indexes also. Each ARM is connected to a particular index. You can select a lender and a loan according to the index that is applicable on the loan. Get to know from the lender about the past performance of each index. You should target at finding an ARM which is linked with an index which has remained reasonably constant over the years.
• Margin: Margin refers to the interest rate which combines the lenders business cost along with the profits they are predicted to make by providing the loan. The margin plus the index rate gives the total rate of interest. This usually stays constant throughout the tenure of your home loan. When you are choosing between lenders, make sure you take into account the index as well as the margin rate that is being offered.
• Adjustment Period: This refers to the time between probable interest rate balancing and adjustments. You may observe an ARM being indicated with the help of figures like 1-1, 3-1, and 5-1. In each of the set, the first number points to the initial loan period, during the time when your rate of interest will be the same since the day your loan started. The second figure refers to the balancing or adjustment period, depicting how frequently adjustments may be done to the interest rate after the initial period is over.
• Interest rate caps: These refer to set limits on the amount of change of interest rate after each adjustment phase (periodic caps) or throughout the tenure of the loan (overall caps). Payment cap limits the total amount of monthly payment that can be made after each adjustment period. ARMs having payment caps frequently have no periodic rate caps.
• Initial discounts: These are concession interest rate used by lenders for promotional purposes. These are usually offered in the initial phase of a loan. The interest rate provided is lower than the prevailing rate.
• Negative amortization: Negative amortization takes place when payments are not sufficient to take care of the interest cost. The amount that is unpaid is combined with the loan thus generating even higher interest debt. If this is allowed to continue, you will be making several more payments and still be continuing to owe greater amount as compared to the starting phase of your loan.
Sometimes flexibility as regards conversion of ARM to a fixed rate mortgage is provided by the lender. You should also look into prepayment terms in case you payoff the ARM early.