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Mortgage Glossary
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| Adjustable-Rate Mortgages |
| Adjustable-rate mortgages (ARMs) differ from fixed-rate mortgages in that the
interest rate and monthly payment can change over the life of
the loan. ARMs also generally have lower introductory interest
rates vs. fixed-rate mortgages. Before deciding on an ARM, key
factors to consider include how long you plan to own the property,
and how frequently your monthly payment may change. |
| Why choose an adjustable-rate mortgage? |
| The low
initial interest rates offered by ARMs make them attractive
during periods when interest rates are high, or when homeowners
only plan to stay in their home for a relatively short period.
Similarly, homebuyers may find it easier to qualify for an ARM
than a traditional loan. However, ARMs are not for everyone.
If you plan to stay in your home long-term or are hesitant about
having loan payments that shift from year-to-year, then you
may prefer the stability of a fixed-rate mortagage. |
| Components of adjustable-rate mortgages |
| Adjustable-rate
mortgages have three primary components: an index, margin, and
calculated interest rate. |
| Index |
| The
interest rate for an ARM is based on an index that measures
the lender's ability to borrow money. While the specific
index used may vary depending on the lender, some common
indexes include U.S. Treasury Bills and the Federal Housing
Finance Board's Contract Mortgage Rate. One thing all
indexes have in common, however, is that they cannot be
controlled by the lender. |
| Margin |
| The
margin (also called the "spread") is a percentage
added to the index in order to cover the lender's administrative
costs and profit. Though the index may rise and fall over
time, the margin usually remains constant over the life
of the loan. |
| Calculated interest rate |
| By adding the index and margin together, you arrive at the
calculated interest rate, which is the rate the homeowner
pays. It is also the rate to which any future rate adjustments
will apply (rather than the "teaser rate," explained
below). |
| Adjustment periods and teaser rates |
| Because
the interest rate for an ARM may change due to economic conditions,
a key feature to ask your lender about is the adjustment period--or
how often your interest rate may change. Many ARMS have one-year
adjustment periods, which means the interest rate and monthly
payment is recalculated (based on the index) every year. Depending
on the lender, longer adjustment periods are also available. |
| An ARM
can also have an initial adjustment period based on a "teaser
rate," which is an artificially low introductory interest
rate offered by a lender to attract homebuyers. Usually, teaser
rates are good for 6 months or a year, at which point the loan
reverts back to the calculated interest rate. Remember, too,
that most lender will not use the teaser rate to qualify you
for the loan, but instead use a 7.5% interest rate (or calculated
interest rate if it is lower). |
| Rate caps |
| To protect
homebuyers from dramatic rises in the interest rate, most ARMs
have "caps" that govern how much the interest rate
may rise between adjustment periods, as well as how much the
rate may rise (or fall) over the life of the loan. For example,
an ARM may be said to have a 2% periodic cap, and a 6% lifetime
cap. This means that the rate can rise no more than 2% during
an adjustment period, and no more than 6% over the life of the
loan. The lifetime cap almost always applies to the calculated
interest rate and not the introductory teaser rate. |
| Payment caps and negative amortization |
| Some ARMs
also have payment caps. These differ from rate caps by placing
a ceiling on how much your payment may rise during an adjustment
period. While this may sound like a good thing, it can sometimes
lead to real trouble. |
| For example,
if the interest rate rises during an adjustment period, the
additional interest due on the loan payment may exceed the amount
allowed by the payment cap--leading to negative amortization.
This means the balance due on the loan is actually growing,
even though the homeowner is still making the minimum monthly
payment. Many lenders limit the amount of negative amortization
that may occur before the loan must be restructured, but it's
always wise to speak with your lender about payment caps and
how negative amortization will be handled. |
