Adjustable rate mortgages, also called ARMs, have interest rates that change with time. The interest rates vary based on one of many indexes, such as the rate on treasury bills.
The interest rate is fixed for a given period of time, depending on the term you have chosen, typically 1, 3, 5 or 7 years. It then changes, based on a combination of factors (components) described below.
Adjustable Rate Mortgages usually start with lower interest rates, resulting in lower monthly payments.
They are a great option if you plan to live in the home for only a few years and are not concerned about possible future interest rate increases.
Components of Adjustable Rate Mortgages
These are interest rate concessions, such as promotions offered on the first year or more of a loan. They reduce the interest rate below the prevailing rate.
Intial Interest Rate
The beginning interest rate you are charged on the loan. This can be lower that the prevailing rates if you get an initial discount.
The Index Rate
Lenders tie ARM interest rate changes to changes in an index rate. Lenders base rates on a variety of indices, the most common being rates on one, three, or five year Treasury securities.
Interval of Adjustment
This is the length of time that the interest rate on an ARM remains unchanged. The rate is reset at the end of this period based on the stated Index Rate, and the monthly loan payment is recalculated.
At the end of the initial rate term your interest rate will be recalculated. A margin (a type of price markup) is added to the index. The index plus the margin will give the new adjustable rate that kicks in after the initial term.
Rate Cap and Payment Cap
The rate cap is the maximum interest rate increase that can occur at each interval of adjustment.
The payment cap is the maximum amount that your payment can go up at each adjustment interval.
This means the mortgage balance (loan principal) is increasing and occurs if the monthly mortgage payments are not large enough to pay all the interest due on the mortgage. This may be caused when the payment cap is set too low.
The agreement with the lender may have a clause that allows the buyer to convert the ARM to a fixed-rate mortgage at designated times.