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ARM Is this the Best Mortgage Loan for You?

While there are many different types of mortgages, one of the most popular is the Adjustable Rate Mortgage, also referred to as ARM. In this case, the amount of interest would fluctuate based on the current market. Because of this, the monthly mortgage payment would increase or decrease as interest rates change.

Understanding ARM Terminology

Index

The index is actually a lenders guide for measuring changes in interest rate. The most common types of indexes used are one, three, and five-year treasury securities, which are based on activity, although other indexes are also used. The type of index used would be directly connected to the specific ARM.

Margin

The margin is the amount of markup for the lender. For instance, this interest rate would symbolize cost for the lender to secure loans, in addition to the amount of profit the lender would make on each loan. To determine the homebuyers exact interest rate, the margin would be added to the index rate, which typically remains unchanged throughout the life of the loan.

Adjustment Period

In this case, the adjustment period is the amount of time between possible adjustments for interest charged on the ARM. When looking at Adjustable Rate Mortgages or ARMs, sometimes this type of loan is represented as a 1-1, 3-1, or 5-1, which mean specific things.

For instance, 1-1 is a reference to the initial period that the interest rate on the loan would remain unchanged, based on the rate set during home closing. The second reference is known as the adjustment period, which indicates the frequency of which adjustments could be made to the interest once the initial period concludes. A prime example would be annual adjustments for an ARM, meaning adjustments might occur annually.

ARM Indexes

Every lender uses a different type index for an ARM, something you would not know but what you can find out is the index the lender would use based on the type of loan you secure. Additionally, you could ask your lender about past index performance, helping you find an ARM connected to the index that has shown the most stability and for the longest amount of time. Therefore, as you consider a bank, mortgage company, or other mortgage lender, you need to look at the index, but also the margin rate offered.

Buy-Downs and Discounted Rates

Sometimes when buying a home, a seller will agree to pay fees for a buy-down, which means the lender would have the ability to offer an initial interest rate that falls below the total amount of index and margin combined. While not offered by everyone, some builders of new homes provide this incentive to sweeten the deal.

Remember, this rate will expire and if the loans interest rate were being adjusted upward at that time, the amount of the monthly mortgage payment could increase dramatically. Additionally, you want to be careful in that sellers will sometimes increase the asking price of the property just enough to cover the loan buy-down. In this case, the seller pays nothing but to the buyer, it appears as if a legitimate discount were being offered.

Interest Rate Cap

Many ARMs have a cap on interest rate so there are limitations to the amount of change, up or down. Caps are broken down into two categories, which include:

1. Periodic In this case, the interest rate could increase but only from one adjustment period to another adjustment period but some ARMs will not provide this type of interest rate cap.

2. Overall – With this type of cap, the amount of increase would also be limited but over the entire life of the loan, something enacted by law in 1987.

Payment Caps

This type of cap is associated directly with the monthly mortgage payment, which dictates the amount of increase during the adjustment period. Typically, if an ARM has a payment cap then a periodic rate cap would not exist.

Carryover

If the ARM has an interest rate cap that has kept the amount of interest down during the adjustment period, even if the index increased, this increase could be carried over to the next adjustment period, which could be beneficial to the buyer.

Negative Amortization

An amortization is the point where mortgage payments are substantial enough to pay due interest in addition to some of the loans principal. However, in the situation of a negative amortization mortgage payments would not be large enough to cover the interest. Therefore, the amount still owning would be added back onto the loan, which ultimately means the amount of debt specific to interest becomes greater. What happens with negative amortization is that even while making monthly payments on the loan, the balance actually increases.

With Changing Payments, is an ARM a Good Consideration?

The answer is yes for many people. With an ARM, what happens is that the initial interest rate would actually be lower than you would get with a Fixed Rate Mortgage or FRM, which is another mortgage loan in which the interest never changes. By securing a mortgage loan with lower interest, payments are lower and for some people, this could be the difference between qualifying or not, as well as the amount of loan.

Other Considerations for an ARM

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* You need to think about the amount of time you expect to own the home. In this case, if you will only own the property for five years or less, than any rate increase with an ARM would have little to no effect.

* You also need to determine if your income has potential for increase, which would make the slowly increasing house payments easier to pay.

* Keep in mind that often a person could have the ARM converted into an FRM. The consideration here is that the cost associated with the conversion might absorb any cost savings, therefore, not being worth the effort.

Remember, with an ARM or any type of mortgage loan, lenders are required by law to provide information to the borrower in writing. With this, borrowers can make the appropriate comparisons between lenders, loan types, and interest rate so they make the best possible decision. Of course, buyers should always ask questions to be sure they fully understand the various components of an ARM or any home loan.

Oliver Darraugh has been a Realtor for over 10 years. He writes widely about issues related to real estate and finance. He is currently studying the latest property developments in the UK and establishing online house buying companies to speed up the process of selling houses during this economic slowdown.