## Educational Consumer Tips

Author:
Rachel Gelb

Published: 4/29/2014

Category: Finance

**What is an Adjustable Rate Mortgage (ARM)?**

An adjustable rate mortgage is a mortgage with an interest rate that changes, periodically, during the life of the loan, according to a specified index and time schedule.

Since interest rates for fixed-rate financing remain the same for the life of the loan, a lender may lose money if for example, inflation increases interest rates. As a result, the adjustable rate mortgage was created to balance the risks from changing interest rates between a lender and borrower. **Choosing an ARM: Pros and Cons** The type of mortgage you select to finance your home will depend on a number of variables specific to your individual situation. These variables can relate to your current level of income, amount of liabilities, expectations of future income, or length of time you plan to live in your home.

ARMs are popular because of the lower initial interest rate, as compared to an often higher interest rate for fixed-rate financing. The lower interest rate makes it easier to qualify for a loan because less income is needed. In addition, the lower interest rate may allow you to borrow more money and purchase a larger, or nice home.

ARM borrowers, generally, are not "locked-in" to high marketplace interest rates that may occur at the time they obtain their loans, since ARM interest rates will decrease if rates decrease. Also, if you only expect to live in your house for three to five years, an ARM may be the best choice because the initial interest rates are lower.

On the other hand, an ARM does not allow the borrower to anticipate precisely what mortgage costs will be over the life of the loan. At each adjustment period, your ARM interest rate and monthly payment may change. As a result, it may be difficult to plan your finances. *Basic Characteristics***To know how an ARM works, you must understand the following basic characteristics of this type of mortgage.** **Interest Rate:** ARMs typically offer an initial rate of interest that is below the rate for fixed-rate mortgages. This initial interest rate can be in effect for a few months, or for several years, depending upon the terms in the ARM.

When the initial interest rate period ends, interest is then determined on the basis of an index. Indexes that are often used include the U.S. Treasury Constant Maturity Rates (CMTs), the Cost of Funds Index (COFI), or the one-year Treasury Bill Index.

The particular index used to set interest rates for an adjustable rate mortgage is very important. Generally, an index that follows long-term market interest rates is less changeable, which means the borrower has a better chance at more consistent interest rates.

While lenders may choose which marketplace index is used for an ARM, they have no control over the index values. Whatever index the lender chooses, make sure you understand:

The basis for the index being used; How that index performed in the past; and What changes in the index would mean to your future mortgage payments.

The lender adds a margin amount to the index value. Although the index value may change, the margin is set at the beginning of the loan and does not change. The index value plus the lender's margin equals the ARM interest rate.

Note, some lenders may offer a "discount" rate which is an initial ARM rate that is lower than the sum of the index value and margin. Make sure you consider whether you can afford payments, in the future, when the discount expires and the adjustment is made to the rate. **Adjustment Period:** The loan documents will tell you how often interest rate changes may occur. Although the rate change could occur every month, it is more likely that it will change every several months, or once a year.

For example your loan agreement may state that the adjustment period occurs once a year on January 1, and your ARM interest rate is 12%. If, on February 1 of that same year the index increases, you would still maintain the 12% ARM interest rate until the following January 1, when your ARM interest rate would be recalculated. Depending upon changes in the index, your ARM interest rate may go up, down, or remain the same. **Interest Rate and Payment Caps:** Most adjustable rate mortgages have limits on the percentage amount that the ARM interest rate can rise at each adjustment period, and over the life of the loan. These periodic, and overall caps protect you from a large payment increase when the adjustment is made to the interest rate.

For example, a loan agreement may state that the ARM interest rate cannot rise more than 2% at any adjustment period, or more than 6 percentage points for the life of the loan. So, if your ARM interest rate begins at 10%, you know that your ARM interest rate will not rise above 12% at your first adjustment period, and never above 16% for the life of the loan.

A payment cap may also be included in an ARM, which limits your monthly payment increase at the time of each adjustment period, usually to a percentage of the previous payment. Many ARMs with payment caps do not have periodic interest rate caps. **Negative Amortization:** Although most ARMs are paid off within the loan term, usually 30 years, you should be aware of unusual terms of your ARM that may cause your loan balance to increase rather than decrease. An increasing loan balance is called negative amortization.

Negative amortization can occur if your loan has terms that state your monthly payment increase may be capped below the amount required to fully reflect the change of your loan's interest rate. If your monthly payment does not reflect your loan's interest rate, then the unpaid interest is added to the loan balance.

If negative amortization occurs and your loan balance increases, you may be responsible for an unexpected large payment to decrease your loan balance to a stated amount.

Make sure you ask the lender if there is a loan extension clause in the ARM agreement that allows for additional time to pay off the loan, if negative amortization occurs.

**Computation Considerations** When computing the new interest rate at the adjustment period, you should first review your mortgage documents and identify all the major parts of your payment computation, which include the index rate, margin, caps, and any other factors. Next, go to your library and find your index. Some index rates may be published in your local newspaper. Then, with all the major components in hand, do the math to figure out your ARM interest rate.

**Rounding -** Remember, at the adjustment period your interest rate is recalculated based on a new index figure plus the lender's margin. Because the numbers may be uneven, there may be a clause in your agreement for rounding. However, you need to know exactly how the rounding is done. Is rounding done to the nearest 1/8 of a percent, or "up" to the nearest 1/8 of a percent?

Rounding to the nearest 1/8 of a percent allows the rounding to go up or down, whereas rounding "up" to the nearest 1/8 of a percent can only go up, which is more costly to you.

If you are shopping for an ARM and find two ARMs with all features equal except the initial interest rate, the rounding "up" technique may make the ARM with the lower initial rate more costly over the long run.

**Miscalculations -** If you are having trouble with the calculations, or your results differ from the mortgage company's calculations, contact your loan officer at the mortgage company. The loan officer should be able to answer your questions, and offer an explanation about the method of calculation for your ARM.

Computation mistakes may occur when recalculating the new interest rate at the adjustment period, because there are so many changing parts to an ARM. For example, errors may involve the use of incorrect index values, or margins.

Government agencies, as well as independent companies, have studied ARM miscalculations. Although there is disagreement as to the severity of miscalculations, there is agreement that mistakes can, and do, occur.

If you disagree with the mortgage company's figures and cannot resolve the problem, you can contact your state's consumer protection offices, or banking authorities, for assistance.

**Information and Resources** A federal law, the Truth-in-Lending Act, requires a lender to provide you with a disclosure statement about the cost of your credit, and an information booklet on adjustable rate mortgages.

The law also requires mortgage advertisers to give specific information about the terms of the loans they advertise, including the annual percentage rate (APR).

If you need assistance with calculating the new interest rate, there are books available that provide the specific steps to figure out your ARM payment at your adjustment period. Check with your local library.

*Tips to Remember *

**Before you sign an ARM agreement, make sure you know the answers to the following questions:**

- What is the current interest rate for fixed rate financing?
- What is the initial interest rate for the ARM?
- What is the initial monthly payment?
- How long does the initial interest rate last?
- Is there a discount rate, and how will it affect the initial payment?
- How often does the adjustment period change?
- Is there a cap that limits the size of the payment change?
- How much notice must the lender give before each payment change?
- What index is used at the adjustment period?
- Where is this index published?
- What is the margin above the index rate?
- Is there a cap on the percentage amount that the ARM interest rate can rise at each adjustment period?
- Is there a cap on the loan's maximum interest? Is there an interest minimum?
- If the month payment does not reduce the mortgage principal balance, is negative amortization permitted?
- If there is negative amortization, can the loan term be extended? If so, to how many years?
- What is the policy on paying the ARM off early? Are there any special fees, or penalties involved?
- Can the ARM be converted to a fixed-rate loan in the future?

## Rate this tip

*Rate this tip by choosing the stars below.*

**Average Rating:**