Grand County Real Estate: Understanding Adjustable Rate Mortgages
February 24, 2008
You’ve probably heard a lot about ARMs in the news lately, but many
people still find them confusing. The rate changes, but how?
An ARM, like the fixed rate mortgage (or FRM), has two elements:
The interest rate and monthly payment.
With a fixed rate loan those items stay the same throughout the life
of the loan. With an ARM, the interest rate changes and this causes
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changes in your monthly payments.
An adjustable rate mortgage has a period in between rate changes
called the adjustment period. A one year ARM has an adjustment rate
period of one year, so that’s how often the interest rate – and your
payments – can change. A 3-year ARM has a 3-year adjustment period,
The interest rate itself has two parts: the index and the margin. The
index determines the interest rate. It may be based on CMT
securities, the Cost of Funds Index (COFI), the London Interbank
Offered Rate (LIBOR) or even the lender’s own cost of funds. These
indexes vary, with some changing more often than others and some that
are generally higher than others. The margin represents how much your
interest rate will be over and above the index. For example, if your
index is 3% with a 3% margin, the rate would be 3% + 3% or 6%.
Following is the formula.
Index + Margin = Fully Indexed rate
Using the formula, if the index rose to 4%, the fully indexed rate
would be 7%. There is a limit on how much your loan can change: It’s
called a rate cap. Rate caps limit how much interest the lender can
There are two main kinds of caps typically used on ARMs:
A periodic cap limits how much your rate is allowed to increase from
one adjustment period to the next.
A lifetime cap limits how much the interest rate can change over the
entire life of the loan. By law, there must be an overall (lifetime)
cap on adjustable rate mortgages.
Note that if the interest rate on a given loan is held down by means
of a periodic cap, if the index were to go up, the lender may be able
to impose the increase at the end of the next adjustment period. For
example, if a periodic cap is 2% but the index rose 3%, the lender
may raise the rate 2% during the present adjustment period and the
extra 1% during the subsequent period.
There is a third cap called a payment cap that limits how much your
monthly payment can go up at the end of each adjustment period.
Usually if your ARM has a periodic rate cap, it will not have a
The reason it’s so important to consider all these caps when
evaluating a loan is to understand the way that your monthly payment
will increase. This is important because it will directly affect the
amount of money you have on hand each month for non-housing expenses.
The incremental increases in the index and rates can be deceptive.
But do the math: If your monthly payment increases from $800 to $1400
over the first seven years of the loan, that is nearly a 50% increase
and could represent a significant burden to your monthly budget.
If you still aren’t sure about your ARM program, get a written
disclosure from your lender. If you are considering an ARM, be sure
to compare the annual percentage rates (APR) and caps on several ARMs
to evaluate which one will cost you less money. A number of years
ago, ARMs were very attractive because the initial interest rate was
substantially lower than the fixed rate. Currently, ARMs do not
offer a large initial interest rate differece and many people are
taking the more conservative route with a fixed rate over the life of
the loan. ARMs are a good fit for a short term investor who intends
to resell the property before the adjustment period.
some of the above information was found on realestateabc.com.
Brenda Kellen can be reached at 970.485.1115 or firstname.lastname@example.org.