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The interest rate on an ARM does not automatically change at adjustment time. A clear understanding of the following factors will explain why and therefore, must be considered when contemplating an ARM:

  • Adjustment period – By definition, and adjustable-rate mortgage has the potential for rate and payment changes at specified predetermined periods every year, three years, or five years.  Other adjustment periods vary from six months to 10 years.  Some ARM’s combine two adjustment periods.  For example, a 3/1 ARM has a fixed-rate for the first three years and then adjusts annually for the remaining life of the loan.
  • Caps are limits placed on how much the interest rate can fluctuate.  The “adjustment cap” is the limit on how much the interest rate can change at each adjustment period.  The “lifetime cap” is the limit on how much the rate can change over the life of the mortgage.  Caps can limit increases by either a dollar amount or a percentage.  The most common interest rate caps specify a 1% to 3% maximum rate increase per adjustment cap, and a 4% to 6% maximum rate increase per lifetime cap.
  • Index is the rate measurement used by lenders to determine any changes to the interest rate charged on ARM’s.  The interest rate on an ARM is determined by an index.  If the index increases, the interest rate will increase unless an interest rate cap has been reached.  The most widely used index is the one-year Treasury Bill Index.
  • Margin which represents the lender’s cost and profit for doing business is added to the index rate which determines the interest rate for the upcoming period.  The size for the margin will vary depending on the index used.  Once the lender has specified the margin, it will remain fixed.  The margin is a critical factor to consider when comparing ARM’s because it can have a significant impact on payments.

On a one-year ARM, adjustments are made annually with each adjustment typically limited to a 1% to 2% increase. A lifetime maximum cap of 6% is common.  One-year ARM’s offer an attractive initial interest rate to borrowers who are willing to accept the uncertainty of future rate and payment changes.  Three and five year ARM’s have adjustment periods of three and five years respectively.  Each adjustment is typically limited to a 2% increase with a lifetime cap of 6%.

            The primary advantage of an ARM is that it provides a lower interest rate initially, in return, for taking a chance with the market that interest rates will be adjusted periodically.  However, this lower initial rate often enables a homebuyer to qualify for an ARM loan when she or he would not have qualified for a fixed-rate loan.

            There are significant drawbacks to ARM’s for lower income buyers, however.  Although there are caps on increases, possible future interest rate increases may result in significantly higher monthly mortgage payments.  ARM’s are best suited for those who expect an increase in income in the future years and/or do not expect to live in the home for more than five to seven years.  Young families who are just starting out their careers are often good candidates for ARM loans.

Convertible Mortgages – Typically, have a single established fixed-rate for three, five or seven years, after which they are converted to market rates for the remainder of the 15 to 30 year term.  Like the ARM, this mortgage also provides lower interest rates in earlier years.  However, the unpredictability of interest rates over time could result in a higher monthly payment at conversion.  The three, five or seven year interest rate is typically higher than an ARM and lower than a straight fixed 30 year amortized loan.

Temporary Buydowns – Often, termed “BUYDOWNS” are fixed-rate or adjustable  rate mortgages that permit homebuyers to make monthly payments for one or two years at 1% or 2% below the first year’s mortgage note rate.  Generally, during the first year of the mortgage, the homebuyer will pay 1% or 2% below the note rate and the second year, 1% below the note rate.  The temporary buydown differs from an ARM in that the difference in the amount paid monthly and the note rate is deposited in an escrow account at closing.  A buydown agreement is signed with the escrow agent agreeing to pay the monthly difference to the lender each month.  Funds for the buydown escrow account can come from a gift, the home buyer, a state or local government agency.  The advantage of a buydown is that it allows you to qualify for the loan at the lower interest rate.

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