Sunday, February 13, 2011 -
By Relocation.com Staff
The adjustable rate mortgage is commonly known as an ARM. An ARM has interest rates that fluctuate and are pegged to one-year treasury bills or to a specific index. Different lenders tie the ARM to different indexes.
Some common indexes are:
- The rate of sales on Treasury notes and bills
- The average rate for loans closed, called the Federal Housing Finance Boards National Average contract Mortgage Rate
- The average rate paid on jumbo CDs (certificates for deposit)
- The costs of funds for the lender
The indexes are usually printed in the newspaper so be sure to check where the rate is published if you decide to go with this type of a loan.
The initial rate of interest tends to be quite low and then the rate jumps up between one to two points per year. Generally there is a yearly cap or one to two points and a lifetime ceiling cap of approximately 5 points. The interest rates can go up or down so this can be a very viable option for people willing to gamble that interest rates will not rise too much. Shopping for an ARM is more difficult than for a fixed rate mortgage. You will need to study all the details of the loan.
Remember, the index is not the actual percentage interest rate you pay following the end of the term for the initial teaser rate but it is only the first part of the calculation. The margin must be added to this to give the actual interest rate. The margin can run anywhere from 1 to 5%. The index plus the margin will give the actual number in percentages that the interest defaults to at the end of the initial term. Initial rates and terms are agreed to upfront. Be sure to ask the true rate and today's rate. This is calculated by adding the index and margin.
The teaser rate is the initial low rate of interest you are charged on the loan. This rate is generally lower than current interest rate. This can be an excellent way of purchasing a home you may not be able to get a fixed rate loan for, as the initial payments will be lower. The bank may give you a loan at this rate but not the higher fixed interest loan. Remember, when the bank is deciding how much they will loan you, they look at how much you can afford each month.
Be sure to understand the adjustment interval on this type of loan. For example, when the interval is two years, the first two years the loan remains at the initial interest rate and then adjusts according to the index and margin used. At the end of the second two-year period the interest rate adjusts again according to the index and margin used and so on until the entire term of the loan is up and the loan is paid off.
The rate caps or payment caps are the next critical piece to examine when looking into this type of financing. A rate caps is the maximum percent the interest rate can go up at the end of each interval. A payment cap is the actual amount your payment can go up at the end of each interval.
In summary when looking at an ARM you need to check out the initial rate, true rate, adjustment interval, caps, index, and margin.
What are the advantages of an ARM?
You may qualify for a loan easier since lenders use the gross monthly income and the monthly loan payment amount to determine how much you qualify. The monthly amount will be less with a lower interest rate so you may qualify for more. If you only plan to stay in the home for a couple of years this may be an excellent choice as the majority of benefits for the initial low interest rate will be gained during this time. If current interest rates aver extremely high, this may be the only loan choice available to you. Yet, if you are not a risk taker, this may not be the best option for you.