Adjustable Rate Mortgage Basics

There are a few basic features of an adjustable rate mortgage that you should be aware of in order to adequately evaluate the risk versus reward that is associated to an ARM.

Fixed Portion of ARM


Let's start with the initial rate that you receive on the mortgage.  The initial rate will remain in effect for a period of 1 month up to 15 years, depending on the type of loan you select.  Once that period is over, the mortgage will convert into a fully amortizing loan; the amortization schedule used to calculate your payments will be determined by your loan type.  Typically, your loan is based off a 30 year amortization schedule and therefore, your loan will be amortized for a period equal to 30 - # of years with initial rate.  For example, if you had a 5 year ARM, your loan would start fully amortizing on a 25 year schedule after year 5.

It is important to note that your payment could drastically increase once the interest rate becomes adjustable.  The general rule of thumb is to look at the the spread between the initial rate and the APR on the mortgage.  If the difference between these two numbers is high, the lender is essentially lumping additional charges into the loan which will come into play once the initial rate period has expired.  Basically, if the spread is high, expect your monthly payment to increase once the initial rate period is over. 

Rate Adjustments


Every ARM has an adjustment period which determines the dates and frequency at which interest rates can change.  For example, a 5/1 ARM is designed to adjust every year after the 5 year initial period.

Index & Margin


Once the initial period of the ARM is over, the interest rate of the loan will adjust based on a general interest rate index which will have a margin added to it.  As this loan has now become a variable rate loan, banks use a published index such as LIBOR , Cost of Funds Index (COFI), or the US Constant Maturity Treasury (CMT) to benchmark the loan's interest rate with an interest rate that represents the current interest rate environment.  This index will be the base component of the rate that the borrower is charged.  Banks will add a margin, or extra basis points, to the index which reflects your credit worthiness and some back end bank fees.  Depending on the prevailing interest rates, your monthly mortgage payment may stay relatively close or may jump dramatically.

Interest Rate Caps


Interest rate caps are exactly what they sound like; they will limit the periodic rate increases on an adjustable rate mortgage.  Caps will typically exists at a periodic level and at a macro level which limits the total lifetime increase.  For instance, assume you have a 5/1 ARM with a 3/2/5 structure.  The 3 stands for the maximum rate increase in the first year after the initial period, 2 represents the maximum rate increase per period and 5 represents the maximum cap over the lifetime of the loan.

<< Part 1- Adjustable Rate Mortgage Introduction
Part 3 - Types of ARMs >>
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