Understanding Adjustable Rate Mortgage

Adjustable rate mortgages, or ARMs, are one of two main types of mortgage loans. As the name implies, an adjustable rate mortgage will change over the life of the mortgage loan and varies as market interest rates move up and down. Typically, you start with a fixed interest rate for a certain period of time then move to an adjustable rate for a much longer time period. Lenders will reward you for taking on the risk of facing high future rates and will charge you low rates during the fixed period. This fixed-rate period can be as short as a year or extend up to 5 or even 10 years.

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Some of the most popular fixed-rate/variable-rate cycles include the 3/1 ARM, the 5/1 ARM, the 7/1 ARM, and the 10/1 ARM. The figures 3/1, stands for a 3-year fixed rate followed by annual adjustments thereafter. They are often called 3/1, 5/1, or 7/1 loans. After the fixed-rate period is over the adjustable-rate will begin and is determined by an index the rate is linked to. The most common indexes are the weekly constant maturity yield on the one-year Treasury Bill, the 11th District Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR).

Other things to keep in mind when shopping for an ARM are the lenders caps and margins. These features are put in place to protect you, the borrower, from extreme changes in rates. Rate caps and payment caps basically limit the amount that your rate or payment will change. The most common caps are lifetime caps, payment caps, and periodic rate caps.

Lifetime caps are put in place to limit how much interest can rise during the lifetime of the loan. Payment caps will limit how much monthly payments rise over the life of the loan and are usually measured in dollars rather than percentage points. The periodic rate cap is put into place in order to limit the amount of percentage points that change over a certain period.

The other thing to be aware of is the margin or addition of percentage points that lenders will add to the index rate in order to cover their costs. These will obviously be different for each lender so make sure to research your choices before settling on a particular loan.