One way of classifying mortgages is by the type of interest rate, i.e. fixed or adjustable. For an adjustable rate mortgage or ARM, the interest rate varies, which means that your due monthly payment could drop, skyrocket or stay the same. One or more indexes are taken into account for calculating the interest rate. Thus, the variations may depend on several factors, which vary from lender to lender. Here are some examples of commonly used indexes:
- Treasury notes and bills;
- The Federal Housing Finance Boards National Average mortgage rate, which represents the median rate for loans closed;
- The median interest rate paid on jumbo certificates for deposit.
The adjustable rate could also be impacted by the lender’s specific costs of funds.
Indexes that influence adjustable rates are usually published in the newspaper. However, you should not count on newspapers alone to tell you about ARM indexes. Making an informed decision about the mortgage is critical for your current and future finances. Before choosing an ARM:
ñ Identify the indexes to understand interest rate adjustments;
ñ See if there are any types of sources for projections;
ñ Talk to an independent financial consultant to help you understand indexes and adjustable rate mortgages.
Unless you understand and speak the mortgage ‘language’, you could get lost in the mortgage market jungle. Interest rates vary a lot, they may go down or up. The ideal candidate for the adjustable rate mortgage is one with little sensitivity to fluctuating expenses. For the average loan buyer, shopping for an ARM loan could prove more challenging than shopping for a fixed-rate home loan.
The benefits of an adjustable-rate mortgage
The due monthly payment could be lower, if the interest rate drops, and borrowers are often lured by this possibility to pay less. With an ARM, there may be chances to borrow a larger amount or to qualify more easily. The mortgage amount is calculated starting from the monthly income and the monthly rate.
Your personal plans for the future matter greatly when it comes to deciding between fixed and adjustable rate mortgage. If you don’t see yourself in the same place in a couple of years, the adjustable rate mortgage could be a good option, due to the initial low interest rate. The choice of an ARM loan depends on income, the current living situation, future plans and willingness to take risks. If you want to keep risks at the minimum, an adjustable interest rate may not be an optimal choice.
ARM details in fine print
Important loan details may be available in fine print, and you need to study them all. The brief explanations below may shed some light on mortgage terminology and introduce you to the basics. Besides information on interest rate and indexes, you should also pay attention to:
- Initial rates
- Adjustment intervals
- Rate caps and payment caps
The Initial Rate or Teaser Rate that the borrower pays is usually below the level of the current interest rate. Since the initial expenses are lower, this could work in favor of the home purchase, particularly if you don’t qualify for a fixed-rate loan. The lender determines the amount that you qualify for by analyzing income and determining the monthly payments you afford. Due to the initial low rate, you could qualify for the loan, whereas with a higher initial rate, you may be rejected on a fixed-rate loan.
The Margin represents the amount added to the index to obtain the actual interest rate. Therefore, do not confuse the index for the interest rate. The rate is calculated based on the index, but that amount alone is not the interest rate you will be paying each month. Variations of the margin are possible. The index plus the margin give the adjustable rate, and this is the amount to which the interest defaults after the first payment.
The interval of adjustment. Understanding the interval of adjustment for the mortgage is a must. If the interval is less than a year, you may find yourself bleeding money. With a one-year interval of adjustment, you will have the same interest rate throughout that period, then, the rate will suffer another change depending on indexes and margin. The fluctuations will continue for the entire life of the loan.
Rate caps and payment caps are concepts that you must get familiar with, when considering getting an ARM loan. The rate cap represents the maximum increase (in percents) that may affect the interest rate when an adjustment is made. The payment cap is the maximum increase of your payment after adjustment. Prior to getting the loan, you need to determine whether you can pay this maximum monthly rate for a full time-interval (1 year in general).