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The lower interest rate of an Adjustable Rate Mortgage (ARM) may be enticing. Just make sure you know all the details before you make a decision.
The major benefit of an Adjustable Rate Mortgage (ARM) is that the initial interest rate is typically lower than what is available for a fixed-rate loan. An ARM is structured to have a fixed interest rate for a specified initial term, after which the interest rate will be recalculated based on the performance of a designated index. There are generally limits set on how much the interest rate can increase during each adjustment period, and the total it can increase over the life of the loan. Before deciding if an ARM is the right loan for you, you will need to understand the various components that make up an ARM.
The initial term of an ARM can range from as short as three months to as long as ten years, with the most popular being one, three, and five years. An ARM that adjusts after one year is commonly referred to as a "One-year ARM." After the initial term, an ARM typically adjusts every year. For example, a three-year ARM has a fixed rate for three years. After three years, the loan can adjust every year for the remaining life of the loan. Most ARM loans are amortized or repayable over 30 years. The length of the initial term could play an important role in determining if this is the right loan for you. If you anticipate selling your home or expect a salary increase before the end of the initial term, an ARM may be a good choice for you. For more information on adjustable rate mortgages, see the Federal Reserve Board's Consumer Handbook on Adjustable-Rate Mortgages.
The index is used by a lender to determine the rate the loan will be adjusted from at the end of the fixed period. It is based on the performance of a designated index, such as one-, three- or five-year treasury securities. It is important to know what index will be used and how often it changes. Knowing the historical stability of a particular index can be useful, although it does not guarantee future performance. HSH Financial Publishers ARM Indexes show the performance indexes of treasury securities over various periods of maturity.
In order to calculate the interest rate of an ARM, you need to know what margin the lender will be adding to the index rate. The margin is the number of percentage points added to the index to determine the interest rate until the next adjustment period. The margin will usually remain constant throughout the life of the loan. For example, if the margin is 2.5% and the index is at 6.0% at the time of adjustment, your new interest rate will be 8.5%.
There are usually "caps" or limits associated with ARM's that govern how much the interest rate can increase within an adjustment period and also over the life of the loan. These caps are put in place to protect the borrower from a drastic payment increase over a short period of time, and to prevent the overall interest rate from rising so high that the payment becomes unmanageable. This allows you to know what the worst-case scenario could be in terms of the highest monthly payment you might be likely to pay.
Here are some basic features of ARMs. There are many variations based on the different combinations of initial term length, adjustment period, index, margin, and caps. For an explanation of different types of ARM, see the U.S. General Services Administration brochure about Payment-Option ARMs. To help you compare ARM loans, visit the CareOne Credit Knowledge Center and use the ARM calculators. You may be a candidate for an ARM if:
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