Here are important facts you need to know about adjustable rate mortgages (ARMs): the definition, its basic features, caps, pricing, and prepayment.
Adjustable rate mortgages, also called ARMs often appear to be great deals for borrowers. But what are they? How do you know if an ARM is right for you? An ARM is a type of mortgage loan that allows a borrower to make lower initial payments for a period of time, typically between one and seven years. Then, the mortgage adjusts for the remainder of the term and often means higher, fluctuating interest rates that can cause a borrower to have difficulty making payments. Rising rates do not happen all the time, and they can happen so that rates decrease which can benefit borrowers. In fact, most borrowers can save a lot of with ARMs in the long run. Let’s go over every aspect of adjustable rate mortgages and see how these can work to your advantage.
Definition
An adjustable rate mortgage is a type of mortgage loan wherein the rate of interest changes depending on index variants.
Basic features
The fundamental features of an ARM are:
- Initial interest rate – this is the first interest rate incurred on an ARM.
- Adjustment period – this is the duration when the interest rate of the loan stays the same. At the end of this period, a new set of rates is given which causes a recalculation of monthly loan payments.
- Index rate – the majority of lenders usually make the changes in index rates as the references for and ARM’s interest rate. You will see sets of numbers such as 1-1, 5-1, 3-1. In every set, first figure represents the initial loan period of the loan in which the interest rates stay unchanged. The second number indicates the frequency, in years, that the interest rates will change after the adjustment period has ended.
- Margin – this refers to two things on the part of the lender. It represents the lender’s interest rate on the cost of carrying the loan. It also embodies the lender’s markup.
- Interest rate cap – this serves as a limit on the rate of interest or the monthly payments allowed to be changed during the term of the loan. The two types of interest rate caps are the periodic cap and the overall cap.
- Initial discount – this is usually offered as promotional help during the first year or so of a given loan. The interest rate is reduced significantly less than the current rate, which is made up of the index and the margin.
- Negative amortization – signifies that the mortgage balance is escalating. This happens every time the monthly mortgage payment is not sufficient enough to pay for the outstanding mortgage interest.
- Conversion – some agreements contain a clause allowing a borrower to convert an adjustable rate mortgage to a mortgage that has a fixed rate at nominated times.
- Prepayment – some agreements require the borrower/buyer to pay out certain amount of penalties and other fees should the mortgage be paid off before the maturity of the loan.
Caps
Caps are limitations on the possible charges designed to limit the risks of financial difficulties on the part of a borrower. Caps are applicable to these three characteristics of ARM: life cap, periodic interest rate change, and frequency of the change of interest rate. There are three types of caps:
- Interest rate adjustment cap
- Mortgage payment adjustment cap
- Total interest adjustment cap based on the life of loan
Pricing
Adjustable rate mortgages are, on the average, less expensive when compared to fixed-mortgage loans. The cost of borrowing depends on the increase and decrease fn the interest rate. Climbing rates cause a rise in cost, while declining rates result in a lowered cost.
Prepayment
An ARM, just like other mortgage types, permits a borrower to pay off the principal amount early without further penalties.
When planning to take a mortgage loan, make sure to look for a competitive broker to assist you. A mortgage broker will assist you in searching for a suitable lender. He should be somebody located near you so you can easily meet up with him to discuss every aspect of your loan.