What is adjustable rate mortgage (ARM) ?

Adjustable rate mortgage or in short ARM is a type of home loan, in which the rate of interest varies throughout the term of the loan and it can increase or decrease according to the market situation. Depending on the amount of loan, the lender can adjust the rate of interest on monthly, quarterly, annually, every 3 years or 5 years. A thorough understanding of ARM’s will help to make a proper choice based on your needs.

The basics of ARMs

To have a complete knowledge of ARMs, you need to understand some of its basic features:

Adjustment Period:

The time duration at which the rate of interest on ARMs remain unchanged. This means that when you get ARM, the initial rate of interest is fixed. As soon as the tenure ends the rate can change at regular intervals. For example, if the time duration of ARM is 5 years then it would remain unchanged for that span of time. After 5 years the rate of interest is adjusted annually on your loan amount.

The index:

The rate of interest depends on the prevailing economic indexes. So when the indexes go up, the rate of interest increases. Likewise, when the indexes go down the rate of interest may drop. The rate of interest varies on the indexes fixed by the lenders. The most common indexes are the rates on United States Treasury securities which are of 1 year, 3 years and 5 years. Apart from these the other indexes are loan associations and national or regional average costs of funds.

The Margin:

The rate of interest is determined by the percentage points that lender adds to the indexes. This margin covers up the cost of their business as well as the profits they make on your loans. The margins remain fixed throughout the tenure of the loan but it differs from lender to lender.

Rate and Payment Caps:

The limit within which you can be charged is known as rate cap. Usually they are of two types-periodic caps and overall caps.

• Periodic caps: It limits the amount at which the rate of interest can increase from one adjustment period to another.
• Lifetime caps: It limits how much the rate of interest can increase during the tenure of the loan.

Negative Amortization:

The stage at which the loan payment fails to cover the cost of interest. This outstanding amount is added back to your loan, generating debts. In this case you can end up paying more than your original amount.

Conversion:

This is an agreement with your lender that enables you to convert your ARM into fixed rate mortgage. The new rate of interest charged by the lender at the time of conversion will be according to the current market rate for fixed rate mortgage.

When you should go for adjustable rate mortgage loan (ARM)?

You should go for adjustable rate mortgage loan in the following situation.

• When you want to go for lower rate of interest at initial level.
• If your income will increase over a period of time.
• You want to make some savings through initial lower payments.
• When you want to own a property for a short period of time say 3 to 5 years, after which you shift to some other place.
• When you are sure that you can make the payments even if the rate of interest increases at a later stage.

The bottom line is that, when you make up your mind to go for ARM, ask you lender all possible questions that may come up in your mind. The lenders are bound to provide you the right information regarding the present rate of interest and market conditions. Lastly make a detailed financial planning and know every aspect of ARMs and other types of home loans that are offered to you.