Sunday, July 25, 2010

How an Adjustable Rate Mortgage Works

Many first time home buyers have the option to buy a home with an Adjustable Rate Mortgage (ARM for short), but many of these consumers may not understand how an ARM really works and whether it is the right choice for them. This article focuses on explaining how an ARM works and what some of the common terms associated with an ARM mean.

Almost all home buyers have heard of the term '5 Year ARM', but what does this really mean? The most important thing to know about an ARM is that the interest rate on such a mortgage is adjustable and can change throughout the lifetime of a mortgage. However, there is a certain period of time that an ARM's interest rate does not change referred to as the Adjustment Period. When you hear the term '5 Year ARM', you are being told the Adjustment Period of this loan. Do not confuse the Adjustment Period of an ARM with its Term (the life of the loan) which is usually 30 years. Simply put, a 5 Year ARM is an adjustable rate mortgage whose interest rate remains fixed for the first five years of the loan but will become adjustable for the remaining 25 years of the loan.

All Adjustable Rate Mortgages have an initial interest rate, also referred to as a 'teaser rate', that stays constant during the adjustment period. However, after the adjustment period, this initial interest rate can suddenly change to a higher value thereby increasing your monthly mortgage payment. There are limitations, though, to the amount that your interest can change. These limitations are known as Index, Margin, Periodic Rate Cap and Lifetime Rate Cap.

All Adjustable Rate Mortgages are tied to an Index. An Index is basically a financial instrument that has a rate that varies. Common examples of Indexes that many ARMs are tied to are the LIBOR (London Inter Bank Offered Rate) or the US T Bill (United States Treasure Bill). One of the other important parts of an ARM is its Margin. In the context of an ARM, Margin is the amount of profit that your bank will tack onto the Index. If your ARM is tied to an Index such as the LIBOR, after your Adjustment Period when your mortgage's interest rate becomes variable, your bank will set your new interest rate based on the price of this Index plus a Margin. It is OK if you are confused, I will show you how this all works in an example at the end of this article.

Because of the lack of control that home buyers have on the behavior of an Index, a common concern is that a sudden change in their interest rate can occur if the Index that their ARM follows suddenly increases. To help protect consumers against such wild shifts, every ARM has a Periodic and Lifetime Rate Cap. A Periodic Rate Cap sets an annual limit by which your ARM's interest rate can change by. A Lifetime Rate Cap sets the maximum interest rate that you will ever be charged on your ARM. Banks do not typically advertise their Periodic and Lifetime Rate Caps so you should ask them what these rates are when you are shopping around for your mortgage.

Now, let's work through an example that brings all of these concepts together. For a clear visual demonstration of this example, open this Adjustable Rate Mortgage Calculator in a new window and follow along. In this example, let's assume that you are shopping for a $100,000 mortgage and your bank offers you a 30 year Term Adjustable Rate Mortgage that follows the LIBOR with a 5 year Adjustment Period, a 5.5% Initial Interest Rate, a Margin of 1%, a Periodic Rate Cap of 2%, and a Lifetime Rate Cap of 10%.

In this example, for the first 5 years of your mortgage, your interest rate will be set to 5.5% and your monthly loan payment will be $567. After your 5 year Adjustment Period is over, let's assume that the LIBOR has jumped to 12%. When you account for the 1% Margin, your interest rate could theoretically jump to 13%! However, because you have a 2% Periodic Rate Cap, your interest rate between year 5 and year 6 will increase by 2% to become 7.5% (monthly loan payment of $683). Similarly, between year 6 and year 7 your interest rate will increase by another 2% to become 9.5% (monthly loan payment of $804). Between year 7 and year 8, however, your interest rate will not jump by 2% to become 11.5%, but will only increase by 0.5% to hit your Lifetime Rate Cap of 10% (monthly loan payment of $835). Assuming that the LIBOR does not fall below 9%, your interest rate will remain at 10% for the remaining 22 years of your loan.

With this understanding of how an adjustable rate mortgage works, you are prepared to work with your lender confident that you understand how an ARM is going to impact your loan payment and if this impact fits within your budget.


 

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