Adjustable Rate Mortgages - A Snapshot

An Adjustable Rate Mortgage (ARM) sets itself apart from traditional 15 and 30 year fixed rate mortgages by a) having an interest rate that adjusts to market conditions periodically and b)gives borrowers more options (and, consequently, more risk) when it comes to borrowing, repayment and more.

When you are approved for an Adjustable Rate Mortgage you get an introductory rate (usually less than current fixed rates), an adjustment period, an interest rate or payment cap and an index that will be used to determine the adjusting interest rate.

The introductory interest rate on an Adjustable Rate Mortgage is lower than that of a fixed rate mortgage because the borrower is assuming more of the risk. Think of it like this: you borrow money from a lender and the lender borrows money from a bigger lender. The lender has to pay interest to their lender for your mortgage. The interest your lender pays changes with the market rates. If they lend you money at a fixed rate they are assuming what is referred to as "interest risk." If the interest rates change they make less money on your loan because they have to pay more interest on it (while not being able to charge you more). With an Adjustable Rate Mortgage the lender assumes less interest risk because they have passed it on to the borrower. This allows them to charge a lower introductory rate.

The adjustment period on an Adjustable Rate Mortgage is the period that the interest it readjusted in. This can be 1 month, 1 quarter, 1 year, 3 years or 5 years depending on the mortgage. Lower adjustment periods will command a lower introductory rate because, again, the lender assumes less of the interest risk when they can transfer that risk to the borrower more frequently. An interest or payment cap is the maximum amount of money that the lender can charge the borrower regardless of how high the interest rate climbs. Obviously, interest cap refers the maximum amount of interest can be charged on an Adjustable Rate Mortgage and a payment cap refers to the highest possible payment.

Finally, the index is what is used to set the interest rate on the loan. When a borrower charges interest on an Adjustable Rate Mortgage they charge an index and a margin. The index is what the mortgage costs them and the margin is the rate they add on top to make money on the mortgage. The inded is a method of determining an interest rate based on specific market factors (which change from index to index). The most popular indexes used today include the 1-year Constant Maturity Treasury Securities (CMT), Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR).

The most popular types of Adjustable Rate Mortgages include Fixed Period ARMs, Interest Only ARMs, Minimum Payment ARMs, Hybrid ARMs and Option ARMs. Each type of Adjustable Rate Mortgage carries with it its own advantages and risks for borrowers. Having a solid understanding of these benefits and risks will save a lot of heartache from mortgage mistakes.

First, a Fixed Period Adjustable Rate Mortgage is very similar to traditional fixed rate loans. It has a set term of 15, 30 or 40 years. The only difference is that the Fixed Period ARM has an adjustable interest rate.

An Interest Only Adjustable Rate Mortgage is just as its name states. The borrower pays only interest for a predetermined number of years (usually 3-10). Once the interest only period ends the mortgage payment increases even if interest rates remain the same. This is due to the fact that nothing has been paid on the principal.

A Minimum Payment Adjustable Rate Mortgage has the absolute lowest monthly payment that a borrower is willing to accept. Often this is less than the interest due for that period, which creates a negative amortization effect (the interest that went unpaid is added to the mortgage principal). That said, the payment begins to rise because the principal itself rises and, in turn, makes the interest rise because its being calculated on a higher principal. This makes it plain to see that a Minimum Payment Adjustable Rate Mortgage can quickly escalate to a bad debt situation if only the minimum payment is made every month.

A Hybrid Adjustable Rate Mortgage is a mortgage that has a fixed interest rate for a set number of years then becomes an Adjustable Rate Mortgage for the remainder of the loan term. These are usually expressed as a ratio like 3/1 which means the loan is fixed for three years and adjusts once every year after that.

An Option Adjustable Rate Mortgage comprises all of the above mortgages. With this ARM the borrower decides which payment they would like to make for that month. This would include a fully amortizing payment (interest and principal), interest only or a minimum payment (usually negatively amortizing).

Adjustable Rate Mortgages are a very powerful financial tool but they must be used with caution and a clear and focused plan. If used to max out home buying potential a borrower may soon find themselves foreclosing and/or going bankrupt. It's very important to carefully review every detail of an Adjustable Rate Mortgage before signing on the dotted line.