Adjustable-rate mortgages, also called ARMs, offer an
interest rate and monthly payment that fluctuate according to market
interest rates.
Most ARMs start out with a lower initial interest rate
than fixed-rate loans. During this initial period, the borrower's
rate remains the same. After the initial period expires, the
interest will reset at preset amounts of time.
The initial interest period can be anywhere from a
month to 10 years. One-year ARMs are fairly popular. They begin
adjusting in interest after one year. But in the last few years,
five-year ARMs have increased in popularity. They have a fixed
initial interest rate for five years after which they adjust
annually. The five year and other ARMs with lengthy initial interest
periods are known as hybrids. You will often see hybrids written as
3/1, 5/1 or 10/1. The first number is the initial period; the second
number is how often the interest rate adjusts. So for 3/1, the
interest rate is fixed for three years and then adjusts once a year
for the remainder of the mortgage.
After the fixed-rate period, the loan will adjust at
the same rate as an index that is spelled out in the closing
paperwork. The lender will look at the index, add a margin to the
figure and adjust the borrower's interest rate accordingly. This
happens every time an adjustment date rolls around.
Most rates for adjustable mortgages are tied to one of
three major indexes:
The weekly constant maturity yield on the one-year
Treasury Bill;
The 11th District Cost of Funds Index (COFI); or,
The London Interbank Offered Rate (LIBOR).
With an ARM, when the interest rate increases, the
monthly payment increases. When the interest rate decreases, the
monthly interest rate follows.
Most ARMs come with caps to keep the borrower's
interest rate from skyrocketing. These are usually annual caps that
prohibit how much an interest rate can increase during a year.
Look for three different types of caps when looking at
mortgages with adjustable rates:
Periodic rate cap: This cap limits how many percentage
points the rate can change at any one time. These are usually annual
caps that prevent the rate from rising more than a certain amount in
one year.
Lifetime cap: This cap limits by how much the rate can
rise over the entire life of the loan.
Payment cap: This cap is offered on some ARMs. It
limits how much the monthly payment can rise over the life of the
loan in dollars, rather than the change in interest rate.
In the last few years, new forms of ARMs have emerged.
One of these is the interest-only mortgage. These were originally
offered to "affluent customers," but are increasingly popular with
many different levels of borrowers. The borrower is only required to
pay the interest that accumulates on the loan for a specific period
of time, for example 10 years. After the first 10 years are up, the
rate begins adjusting on an annual basis. The borrower will also be
required to start paying back the balance on the mortgage as well.
Interest-only mortgages allow borrowers the
flexibility in the size of monthly payments. They are often a wise
fit for those who expect their income to increase in the future. You
should be aware of the increase of the monthly payment when the
principal is due and when the interest starts amortizing.
Some ARMs will allow you to convert to a fixed-rate
mortgage for a fee, called a conversion. Other ARMs allow borrowers
to make minimum payments on their mortgage for a certain period of
time. The availability of so many options makes ARMs difficult to
understand.
Make sure that you ask your lender
if the ARM is convertible to a fixed-rate mortgage. You should also
ask if the mortgage is assumable. Make sure that you understand all
the terms and the potential interest rate you may be facing with an
adjustable rate
mortgage.
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