Explain An Adjustable-Rate Mortgage To Me!
By: James Hussher
Adjustable-Rate Mortgages
There are basically two types of loan products available to a home owner or purchaser of a home. They can either :
Get a fixed rate mortgage where the payments will remain the same, or
Get an ARM which offers an low introductory interest rate and lower payment, but carries the risk of higher payments later on
There are three important components to an ARM:
The "Index"
The "Margin"
The "cap rate"
The index to an ARM is set by contract at the tiume the loan is taken. It is a basic financial statistic to which the loan is tied, such as LIBOR, the London Interbank Offering Rate, or the 11th District Cost of Funds, or the prime rate, or the Monthly Treasury Auction (MTA), etc. This is the basic "bottom line" of the loan's interest rate, regardless of the intial rate the loan offers.
Added to the Index is a "margin" that is also set by contract when the loan is taken, and it is a numeral, such as 2, or 2.5 that is added to the Index to determine the interest rate on the loan.
So, simply, Index+Margin= Interest rate. Your neighbor and you could have the same ARM from the same bank, but if his margin is 2.5 and yours is 2, he will always have a higher monthly payment than you do.
There is, of course, a limit to how high an ARM can adjust or "recast" from the initial interest rate, and this is called the "life cap". It is important to find this out from your lender at the time you take out the loan.
ARM's have a "honeymoon" interest rate for the first 1 to 10 years and after that they will re-cast at a set interval, tied to the Index for that loan you agreed to originally.
Just like credit cards that have an introductory interest rate that is low and compelling, ARM's can be attractive in the short term but risky in the long term, as adjustments to your monthly mortgage payments can often become excessive to what you can even afford to pay, and then foreclosure looms.
It is important to work with a professional mortgage planner to determine your short and long-term housing and savings goals.
There is also a loan known as the "Option ARM" which offers a borrower a choice of several monthly payments:
Pay principle and interest (plus taxes & insurance), a regular payment.
Pay interest-only
Pay actually less than a regular payment but the difference is added to your loan balance, This is known as a Negative Amortization ("Neg Am") payment. Because your loan balance is actually increasing, not decreasing; yet you remain current on your loan obligation.
Option ARM's usually also offer the ability to "overpay" in certain months and reduce your loan balance more quickly, an acceleration of amortization.
These loans are appropriate for individuals who have income that fluctuates with season, such as accountants who make a lot during tax season and might choose to accelerate payment on the loan principle, and then during "slow" season pay interest only. Or military families who get transferred every 2 to 4 years and don't plan to keep a home for very long. They would benefit from the initial low interest rate and then sell before the ARM "re-casts" to a higher rate and monthly payment.
Be advised thant many ARM's do come with a pre-payment penalty that may require up to 6 months' interest payment penalty if you sell or refinance within the first several years of the loans. Read the fine print of your loan carefully!
As always, consult your professional mortgage planer, CPA, financial planner or attorney when entering into a loan.