Adjustable rate mortgages or ARMs are chosen by about one third of all loan applicants. Unfortunately, many people do not understand the key components of an ARM or how they are calculated. It is critical to understand the four key components of adjustable rate mortgages when comparing loan offers from various lenders.
In general an ARM starts at one rate of interest and then fluctuates up and down during the period of the loan based on several factors. Knowing and understanding these critical factors will help you in your decision making process when shopping for an adjustable rate mortgage. An ARM can be divided into four basic parts: the index, the margin, the adjustment period, and rate caps.
Every ARM is tied to an index. This index is basically a movement of an objective economic indicator. This index can be anything the lender wants to tie your rate to but it is typically indexed to a 1 year treasury note, prime rate index, Cost Of Funds Index (COFI), or London Interbank Offered Rate (LIBOR). Some of these indexes move up and down slowly and others can change very rapidly. So investigate the history of the different indexes and pay close attention to how often they move and how much. Try to choose an index that moves slowly so your rate and monthly payment remain fairly stable over time. Choosing which index to use with your loan is one of your most important decisions when shopping for a loan.
The margin is another important part of any adjustable rate mortgage. The total interest rate you will pay will be equal to the index rate plus the margin. The margin is a number that the lender will add to the selected index. For example, the lender may specify a margin of 2.25%. so if the selected index is at 4% then the effective mortgage interest rate will be 6.25%.The margin represents the lenders cost of doing business and basically equates to the amount necessary to cover their expenses, overhead, profit, lender defaults and foreclosures. Always look at the margin to make sure it is competitive.
The adjustment period is how frequently the lender can change or adjust your mortgage rate up or down based on the movement of your selected index. An adjustment period could be monthly, quarterly, semi annually, annually, every three years, or every five years. Most common adjustment periods are every six months or annually. On every adjustment period anniversary the lender will look at your index and see if it has changed. At this point they will add your margin to the new index rate and this will be your new effective mortgage interest rate until the next adjustment period. Most of the time the longest adjustment period will be best. The longest one will give you the greatest stability in your rate and monthly payment.
The fourth and last part is rate caps. Lenders use rate caps to show how much of an interest rate change is permitted each adjustment period. A rate cap protects consumers from wild swings in their loan index by limiting the increase from period to period. Without rate caps in a volatile market an index could start at 6% and shoot up to 12% by the end of the adjustment period. But with a rate cap of 3% the rate could not be adjusted more than 3% therefore, the new loan rate would only be adjusted up to 9% not 12%. Remember the rate cap is simply the maximum the lender can change your rate at the adjustment period. In general try to get the smallest rate cap possible when shopping among lenders. Using these four factors when shopping for an adjustable rate mortgage should give you a good idea which ones are more competitive.
When buying a house, there are many numbers to take into consideration: price of the house, down payment, your savings, and monthly payments to name a few. It is difficult to find a mortgage, which accommodates all these numbers, but all you need to do is some research. Your circumstance is what you need to consider most when trying to find the right mortgage plan.
With an adjustable rate mortgage (a.k.a. variable rate mortgage), the interest rate you pay on the principal of the loan you took out fluctuates according to posted index rate changes. Risk is a factor involved with this type of mortgage, because it is possible that you might pay more money if interest rates rise and stay raised.
While that is a possibility, so is the possibility of savings if interest rates fall (a bonus to this type of mortgage is the lower initial interest rate). Hence, you may risk higher payments, but you receive a lower interest rate when your loan reaches its fullest point. It is likely this advantage will save you more money than with a fixed rate mortgage, unless interest rates dramatically rise.
If you want the stability and security in knowing your mortgage interest rate will not change with market conditions, you may want to consider a traditional fixed rate mortgage. If interest rates rise, you will be unaffected. In turn, if interest rates drop, you will not be able to take advantage of it.
If you want to secure an adjustable rate mortgage loan, there are both advantages and disadvantages. It may be adventitious if you plan to pay off a large percentage of your balance early in your loan period (hence reducing the bulk of your loan at the initially lowered interest rate). It may also be adventitious if you plan to pay off the loan quickly, or foresee greater future income
To reduce possible risks that come with adjustable rate mortgages, ask your lender about caps or ceilings, which protect you from sharp increases in your monthly dues. This will limit the total possible interest rate increases (legislated in almost all cases).
Finally, You can also consider converting your adjustable rate mortgage into a fixed rate mortgage at a chosen time. A fee may apply, but if interest rates are rapidly rising, it will probably be worthwhile to switch to a fixed rate plan to stabilize your payments. If you're still unsure which plan will best fit your budget and needs, speak with your financial advisor.
Both Terry Parker & Gregg Hall are contributors for EditorialToday. The above articles have been edited for relevancy and timeliness. All write-ups, reviews, tips and guides published by EditorialToday.com and its partners or affiliates are for informational purposes only. They should not be used for any legal or any other type of advice. We do not endorse any author, contributor, writer or article posted by our team.
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