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Adjustable rate mortgage as the name suggest, it is a mortgage for which interest rate is modified according to market conditions. This is exactly opposite to fixed rate mortgage, where the interest rate is fixed for whole term of the loan. With world wide financial crisis especially US banking and mortgage crisis it is important to understand adjustable rate mortgage- how they work and what is it’s impact on you? Before you decide it is important to weigh advantages and disadvantages of adjusted rate mortgage and fixed rate mortgage is suitable for you.
In order to decide which rate is suitable you must first understand how adjustable rate mortgage is calculated. Index and margin are the two factors which determine the adjustable rate mortgage. Index is the standard measure of interest rate for ARM and margin is an extra percent amount added to the index by the lender. In case if the index moves up the interest rate also goes up and hence increase in monthly payments in other case if the index comes down the interest rate also comes down and hence decreases in monthly payments.
There are different indexes upon which the lender bases the ARM rates, therefore it is better to find out which index is used to determine ARM and how it is performed in the past and where to find the information about that particular index.
The margin is the factor which determines ARM rates. Margin may differ from lender to lender, but it will be constant over the term of the loan. Suppose the lender uses the index which is 4% currently and add 2% margin then the total rate adds up to 6%.
Generally margin is determined with your credit score, lender base your margin amount on your credit score. If you have good credit score, lower the margin else higher margin. You can limit an increase or decrease in interest rate with interest rate cap.
There are two forms of interest rate cap: one is periodic adjustment cap which limits the percent of interest rate can be moved up or down in one adjustment period to next one.
And the other one is life time cap. This one limits the movement of interest rate for the life of the loan.
A payment cap can be used to limit the movement upside or downside for the life of the loan. With payment cap can lead to increase or decrease in the term of loan. It is called negative amortization.
What are the features of ARM?
With ARM, lender generally charges lower interest rate initially and it makes ARM useful initially. If the interest rate remains constant or moves lower, this can be advantage to you in long term. However, it is risky if there is increase in interest rate in future, so increase in monthly payments. This initial rate and payment will remain stable for limited period and max of 5 years. After initial period, the interest rate and monthly payments regularly change.
Before you decide any loan, first read the details about the loan.