An adjustable-rate mortgage differs from a fixed-rate mortgage in many ways. With a fixed-rate mortgage, the interest rate stays the same during the life of the loan. With an ARM, the interest rate changes periodically, usually in relation to an index, and payments may go up or down accordingly.
Shopping for a mortgage is not as simple as it used to be. To compare two ARMs with each other or to compare an ARM with a fixed-rate mortgage, you need to know about indexes, margins, discounts, caps on rates and payments, negative amortization, payment options, and recasting (recalculating) your loan.
You need to consider the maximum amount your monthly payment could increase. Most important, you need to know what might happen to your monthly mortgage payment in relation to your future ability to afford higher payments.
Lenders generally charge lower initial interest rates for ARMs than for fixed-rate mortgages. At first, this makes the ARM easier on your pocketbook than a fixed-rate mortgage for the same loan amount. Moreover, your ARM could be less expensive over a long period than a fixed-rate mortgage—for example, if interest rates remain steady or move lower.
Against these advantages, you have to weigh the risk that an increase in interest rates would lead to higher monthly payments in the future. It’s a trade-off—you get a lower initial rate with an ARM in exchange for assuming more risk over the long run.
With most ARMs, the interest rate and monthly payment change every month, quarter, year, 3 years, or 5 years. The period between rate changes is called the adjustment period.
For example, a loan with an adjustment period of 1 year is called a 1-year ARM, and the interest rate and payment can change once every year; a loan with a 3-year adjustment period is called a 3-year ARM.
A 30 year loan, but the rate is fixed for 10 years before adjusting each 1 year for the next 20 years. These loans are typically 5/2/5 – which means a 5% rate first adjustment, 2% each year after, with a 5% lifetime cap (up or down).
A 30 year loan, but the rate is fixed for 7 years before adjusting. Has 5/2/5 caps.
A 30 year loan, with the rate fixed for 5 years before adjusting. Has 5/2/5 caps.
A 30 year loan, with the rate fixed for 3 years before adjusting. This loan typically has 2/2/6 caps – 2% first adjustment, 2% each year after, with a 6% cap.
The interest rate on an ARM is made up of two parts: the index and the margin. The index is a measure of interest rates generally, and the margin is an extra amount that the lender adds.
Your payments will be affected by any caps, or limits, on how high or low your rate can go. If the index rate moves up, so does your interest rate in most circumstances, and you will probably have to make higher monthly payments.
On the other hand, if the index rate goes down, your monthly payment could go down. Not all ARMs adjust downward, however—be sure to read the information for the loan you are considering.
Definition of Common Adjustable Rate Indices
PROPER NAME: Monthly Weighted Average Cost of Funds for 11th District SAIF-Insured Institutions.
This index, used primarily for ARMs with monthly interest rate adjustments, is calculated by the Federal Home Loan Bank of San Francisco. The 11th District represents the SAIF-insured savings institutions (savings & loan associations and savings banks) in Arizona, California and Nevada.
The cost of funds reflects the interest rates paid by institutions for savings accounts, FHLB advances, money borrowed from commercial banks, and other sources.
Since the largest part of a cost of funds index is interest paid on savings accounts, this index lags behind the economy. As a result, ARMs tied to this index rise (and fall) more slowly than rates in general. However, such ARMs often have payment caps, but no month-to-month interest rate caps.
PROPER NAME: Yield on Treasury Security Adjusted to a Constant Maturity of One YearThe One-Year Treasury Security index (or “T-Sec”) is associated with ARMs that feature annual rate adjustments.
It is calculated by the Federal Reserve Board and has both a weekly and monthly value; most lenders use the weekly value. This index reflects the state of the economy and responds quickly to economic changes.
Confusion can arise when some lenders use the term “one year Treasury bill.” Most one-year ARMs — but not all — are tied to the Constant Maturity of the One Year Treasury Security.
Stands for London Interbank Offered Rate. It is a measure of commercial lending rates of a group of London banks. It is similar to the Prime rate. It moves up and down rapidly. It can best be obtained daily from the Wall Street Journal.
This is a measure of what banks are paying on 6 month certificates of deposit. It moves less rapidly than LIBOR or T-bill but more rapidly than COFI.