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The Adjustable Rate Mortgage - How Arms Work
By EchoBay Loans Staff Writer

Imagine getting a mortgage at an incredibly low interest rate, only to find out later that your mortgage payment has increased substantially and the rate you thought you were paying no longer applies to your mortgage loan. What started out as a low-interest loan has suddenly skyrocketed, leaving you unable to make your mortgage payment. If you don't understand the basics of how adjustable rates mortgages (ARMs) work, then this is exactly what could happen.

While the above scenario may be exaggerated because many consumers know the difference between adjustable-rate mortgages and fixed-rate mortgages, that is usually where their understanding ends.
There is a lot more to an adjustable rate mortgage than the fact that the interest rate can change. If you're thinking about taking out an ARM, you'll want to make sure you understand all aspects of this mortgage type.

Understanding ARMs means understanding how, how much, and when rates adjust, the concept of rate caps, and the other issues pertaining to ARM loans. Not all ARMs are the same, and if you're shopping for one, it's important that you know what to look for. Adjustable rate mortgages tend to catch a borrower's eye due to the fact that the interest rates offered on ARMs tend to be initially lower than the interest rates offered on fixed-rate mortgages. However, "initially" is the key word here.

When you have an ARM, it's a safe bet that at some point your interest rate is going to change. When your rate will adjust will depend on your loan's adjustment period. The adjustment period of an ARM is the time between interest rate adjustments. Adjustment periods can occur as frequently as every month or can be spread years apart. Loans that have more frequent adjustment periods tend to have lower initial interest rates than those that have longer adjustment periods.

This is because the lender is assuming very little risk with the loans that have shorter adjustment periods. If the index rate goes up within a few months of making your loan, the lender can pass a higher percentage rate on to you. Because of this, it is better for consumers to go with an ARM that offers a longer adjustment period if an adjustable rate mortgage is what the home buyer wants.

The most common adjustment period is a yearly adjustment period. This means that the interest rate of the ARM will not adjust more than once each year. The way your interest rate adjustment is determined is a bit more complicated than picking a number out of a black hat. Your lender will usually use a well-known financial index as a guideline and will add a margin, or markup, to the current index rate. Not all lenders go by the same index when determining a mortgage rate, so try to find out what index your lender uses. Currently, ARMs that are based on the LIBOR index tend to have a lower interest rate than ARMs that are based on the other indexes.

While all ARMs have interest rates that can change, the amounts that these rates can change varies from loan to loan. There are some ARMs that have a set limit as to the amount that the interest rate can be raised. This is referred to as a rate cap. If you are thinking about going with an adjustable-rate mortgage, it's very important that you understand how these rate caps work. Let's say you are funding your home purchase with an adjustable-rate mortgage and your lender tells you that it has a cap of 2/6. Chances are, you're not going to understand a thing they're telling you. At this point, many people just smile and nod their heads with a glazed-over look in their eyes so that they don't have to suffer the embarrassment of admitting that they have no idea what a 2/6 cap is.

In reality, the cap is not that hard to understand. If you're quoted a 2/6 cap, it simply means that the interest rate on the ARM cannot increase more than 2 percent each time your loan is adjusted and that it can't increase any more than 6 percent over the life of the loan. For example, if you were taking out an ARM with an initial interest rate of 5 percent that had a cap of 2/6, after the first adjustment period your interest rate would not increase to more than 7 percent and the rate could not increase to more than 11 percent over the life of the loan.

While rate caps are great for protecting the amount your payment can go up, payment caps are not. If you were to take out an ARM with a payment cap but there was no cap on the interest rate, you could start to experience a negative amortization if rates were to rise substantially. This would mean that your monthly payment would not cover the principal and interest each month. Because of this, unpaid interest would be applied to the balance of your loan and you would be losing equity instead of building it. Unless you want to see the balance of your mortgage go up instead of down, stay away from ARMs with payment caps.

ARMs are great for people who need a minimal monthly payment at the onset of their loan to free up cash for other purposes. They can also be great for people who don't plan to stay in the home for a long period of time as they allow these people to take advantage of the initially low interest rate and these people will mostly likely move before the rate has a chance to increase substantially. Before deciding which ARM is right for you, find out the details mentioned above and weigh the benefits. You will then be able to make an informed decision that will leave you better off years down the road.

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