Adjustable Rate Mortgage

An Adjustable Rate Mortgage (ARM) is a loan that has a lower initial interest rate for a fixed period of time.  There are many different types of Adjustable Rate Mortgages and the terms used before adjustment range from two, three, five, seven, or 10 years.  This means that for an initial period of time your mortgage will not have a rate change.  Once the designated period ends your rate will change, depending on the parameters outlined in your loan package.

Adjustable Rate Mortgages serve a valuable purpose for many borrowers.  These loans should be carefully considered and explained by you and your mortgage provider.  Here are some of the acceptable reasons for entering into an Adjustable Rate Mortgage. 

Temporary residence at a particular location: If you know that you will not be in the home for the full 30 years and will be relocating after a period of time, then an Adjustable Rate Mortgage makes sense.  Why pay a premium for something you will never use?

Financial situation change in the future:  If you know that your current financial situation will change and you need to qualify for your home, then getting into an Adjustable Rate Mortgage may seem logical.  This is a sensitive subject and should be carefully approached, but if you know that in the future a refinance will benefit you then it is applicable.  You may be coming into some money and pay down enough on your loan that it makes better sense for you to refinance into a different term. 

Lastly, you may enter into an Adjustable Rate Mortgage in situations where the equity of your home may increase substantially during a short period of time.  People will often buy property that has the potential to increase in equity, based on how the condition the home might have been at the time of purchase.  Over time repairs and upgrades are made, thus increasing the value of the home to a point where a new loan can be obtained.  These borrowers will often enter into a 30 year fixed rate agreement after withdrawing cash from the equity gained.

Regardless of what your reasons are for an Adjustable Rate Mortgage, it is important in today’s financing realm that you know everything vital about the terms you are entering into with your mortgage.  Adjustable Rate Mortgages will have a rate change and it will more than likely be an increase in the rate. 

These mortgages are tied to an index and margin calculation.  The Margin is a very rudimentary concept to understand: it is simply the premium added to the base rate that is assigned for the life of the loan.  The most common margin range is 2.0% to 2.75%; however, these margins can be as high as 5.5%, depending on the loan you acquire.  This is the first item you need to review when considering an Adjustable Rate Mortgage. 

The margin represents the premium, but it must be added to something in order to establish your new rate.  Therefore, the margin will be added to an index.  The index used can vary, but traditionally loans will use a London or U.S. based index, known as the Libor or 10 Year Treasury, in order to calculate the new note rate for your loan.

The final item to review in the Adjustable Rate Mortgage is the cap rate portions.  Cap rate portions determine how often and how much your rate can change.  The most popular and best suited adjustable rate caps are single adjustments, which take place annually at a rate no greater than 1% per year.  This maintains control of the loan rate during extreme periods of interest rate increases.

Most people have associated Adjustable Rate Mortgages with the housing crisis we are currently enduring, and the reason we are seeing this is because most people entered into these agreements without knowledge of what the parameters would be for these adjustments.  There are several programs that are designed to fail the borrower, and it is evident in the caps these Adjustable Rate Mortgages will have failed.  This will be explained more in the Subprime section.  It is critical to note that most of these programs would adjust—not once, but twice a year—at a rate of 2% every adjustment period.  They would also carry a margin of 5.5%, which explains why so many of these loans moved into double digit range very quickly.