ARM is the common abbreviation for an adjustable rate mortgage.
The defining characteristic of this mortgage type is that
the interest rate is not fixed for the life of the loan. Instead,
the rate is changed, or adjusted, at a specified time, in
accordance with an index selected when the loan is entered
into. The ARM is a popular choice as a principal mortgage
for many because its initial rate is lower than fixed rate
mortgages, resulting in lower monthly payments at the beginning
of the loan. These lower payments allow many borrowers to
afford a larger loan than would have otherwise been possible.
However, lower initial rates and payments are only part of
the ARM story. There are other factors in ARMs that aren’t
present in other mortgages. One of these is the margin. This
is the amount of interest your lender adds to the index, and
represents his profit on the loan. For example, if the margin
is at two percent and the index is at four percent at the
time of adjustment, your interest rate will be six percent.
Another aspect of ARMs is the adjustment periods. The initial
adjustment period is usually longer than the general adjustment
period. Both periods are given in the name of the loan –
for example, a 3/1 ARM means that the initial rate will stay
in affect for three years, and the rate will be adjusted again
every year until the end of the loan.
If you have been following this discussion closely, you may
wonder why anyone would ever choose an ARM. After all, doesn’t
the risk of skyrocketing interest rates offset any initial
advantage of an ARM? This would seem to be the case, but isn’t
always so because of another ARM feature – rate caps.
All ARMs have a cap on the maximum amount of interest that
can be charged over the life of the ARM.
For example, your ARM may state that you will never be charged
over twelve percent interest. Some ARMs also have periodic
caps, limiting the amount your ARMs interest rate can increase
at each adjustment. However, be warned that if the rate increases
by more than the cap, the remainder of the increase can be
added at the next adjustment.
Overall, ARMs do represent an additional risk to those choosing
this type of loan as their principal mortgages. However, you
may decide that the risk is worth the lower initial rate and
payments. You should always consider the worst case scenario
when determining if an ARM is the right option for you.