An adjustable rate mortgage refers to a mortgage where the interest rate can be changed by the lender according to certain terms and conditions contained in the mortgage contract.
While the adjustable rate mortgage in many countries abroad allow the rate to change at the lenders discretion, in the United States the rates changes are mechanical. The interest rate of an ARM is connected to an Index over which the lender has no control. There are different indexes, much like there are different stock market indices.
This index changes on global factors much like the stock market does. When the index changes, so does the interest rate on the ARM. However, the fluctuation is not quick and sudden. So do not expect constant changes in the interest rate.
These kind of adjustable-rate mortgages that are dependent upon an index rate in the world economy are called indexed mortgages.
A couple of common indexes used are COFI, six-month LIBOR etc.
Why It May Be Easier To Qualify For An ARM
It is easy to qualify for an adjustable-rate mortgage rather than a fixed rate mortgage for the simple reason that the qualification is mostly based on the initial payment that the borrower will be required to pay.
Since adjustable-rate mortgages offer a much lower initial interest rate than a fixed rate mortgage borrowers work with smaller income may qualify for this kind of mortgage even though the payments are slated to rise when the initial rate period is over.
For this reason you may find that adjustable rate mortgages become more common when the interest rate in the mortgage industry are on the rise.
Also with the underwriting becoming more stringent for mortgage loans people who would’ve qualified for a fixed-rate mortgage the past may need to go for an adjustable-rate mortgage in order to qualify.
However, if you are certain that you require fixed rate mortgage but find that you are only getting a qualification for an adjustable-rate mortgage you should know that you can probably qualify for a fixed-rate mortgage if you work a little harder on your application and do a little more research.
It also became common practice after the financial crisis that came about in 2007 to qualify borrowers using the fully indexed rate rather than the initial rate. If this practice would continue it would reduce the cyclical sensitivity in the market share of adjustable-rate mortgages relative to the fixed rate mortgages.
Reasons For Choosing An ARM
Taking an ARM when a fixed-rate mortgage is available is always a gamble. But it is a gamble that could be profitable in the long run. People typically choose an ARM over fixed-rate mortgage when they reasonably expect that the interest cost in total will be lower on the adjustable-rate mortgage than a fixed-rate mortgage.
The present ARM contracts have a cap on how high your interest rate and the mortgage payments can go. So in other words, you know what the worst case scenario could be. People take this into account and figure out whether they can meet this change comfortably if it happens.
People usually take ARMs for a couple of reasons. If the interest rates are high right now, they will gain when it comes back down. This does not happen with an FRM.
They are also willing to take on the gamble that in the long run, or for as long as they hope to posses the house, an ARM will give them better results.
It is highly recommended that you speak to her financial professional before choosing a adjustable rate mortgage to purchase your home.
- An adjustable-rate mortgage has an initial low payment. The length of this period depends on the agreement between you and the lender.
- If you want to sell the house in the near future, you can take advantage of the fact that an ARM usually has a lower rate of interest than any other mortgage, as decided upon between you and the lender.
- The borrower expects to pay a lesser amount of money over the entire life of the adjustable rate mortgage. The only home loan where you can actually expect to pay lesser than what you signed up for, is the ARM. If the current home loans interest rate is high, it makes sense to go with an ARM. When the interest rates adjust in the future, you mortgage payment will go down along with it.
What Is Rate Index and Margin Rate
The rate index and the margin rate are two factors that determine the total interest rate on an adjustable rate mortgage. These are the two variables that control how the interest rate payable on the ARM fluctuates in the future, within the rate caps as per your loan contract.
ARM Index Rate
The index rate is an interest rate trends that lender uses to calculate the interest on the mortgages interest rate. Several rate indexes exist such as the six-month bank certificate of deposit. This is nothing but the interest rate on a savings certificate of deposit.
This index theoretically indicates how much it costs the bank to taking money. For example this is the amount that the bank has to pay back people who are investing money with it.
Lenders cannot control any of these indexes that we are going to discuss. Some of the common rate indexes are treasury bills, certificate of deposit, The 11th District Cost of Funds Index (COFI) and the London Interbank Offered Rate Index (LIBOR).
Some of these indexes are more volatile than others which means they are more sensitive to the fluctuations in the market. Generally more stable indexes are preferred by both the lenders as well as the borrowers.
ARM Margin Rate
The margin rate is also known as the lenders profit on the adjustable-rate mortgage. It is the markup he puts on the Index rate which is typically about 2.5%. However this amount will depend upon your lender.
If you’re comparing different mortgage lenders who use the same index, then the margin rate will be the deciding factor as to which mortgage lender is cheaper.
The total interest rate on your ARM is, Margin Rate + Index Rate.
This interest rate that includes the index as well as the margin is called the fully indexed rate and makes for a fully amortized payment on your mortgage. A fully amortized payment means that, if the rate remains constant, making that payment for the entire duration of the mortgage will pay off the home loan completely by the end of the term.
The interest rate on a mortgage can adjust on a monthly basis as well although most are just every 6 or 12 months. You should understand all terms and conditions from your lender. The less frequently your interest rate adjusts, the more stable your loan is.
Other ARM features you should know about
Recasting is the recalculation and readjustment of your payments and interest-rate which a lender might do every five years. When the five years are up the lender might add up your unpaid interest and add it to the principal amount of alone. Based on this new amount your interest-rate or amortisation period may be recalculated. If you have made large payments towards the principal amount of your loan recasting of a variable interest mortgage will result in lower future monthly payments.
ARM Lifetime Floor Rate
The lifetime floor rate in an ARM loan is quite opposite to the lifetime cap it represents the minimum amount of interest below which your interest rate will never fall. Even if the index rate in the market dips beyond a certain point the lender might set a limit on the interest rate beyond which your interest rate will not decrease even if the falling index rate in the market dictates it.
ARM Lifetime Cap
A Lifetime Cap is the maximum interests that the lender can charge the borrower on an adjustable rate mortgage. If this amount is set to 10% in the interest-rate of your mortgage can never increase that amount in any particular month. The lifetime cap Gives the consumer a certain amount of security and provides predictability against inflation in the future. It makes consumers more inclined towards an adjustable rate mortgage as it gives them some idea of what to expect in the future. It also helps the borrower decide whether or not he can afford to stay in the mortgage in the eventuality that the interest-rate might rise in the future. A lifetime cap On the interest prevents the lender from charging unpredictable and wildly fluctuating rates on the mortgage in the future.
ARM Payment Cap
The payment cap Refers to the maximum amount that your monthly payment can increased to in the case of a adjustable rate mortgage. This is usually represented by a certain percentage amounts that is added to the minimum payment. If you have a payment cap of 5% and your minimum payment is $949.07 your payments cannot increase to more than $1020.2 a month in the following year. Payment Cap is one of the safeguards that is implemented on an adjustable rate mortgage. It is to safeguard the consumer from unprecedented and uncomfortably high payments being set in the future by the lender. It is also a check on the lender that guarantees that he will not charge unreasonably high rates in the future once the customer has signed a contract.
What Is Negative Amortisation
Negative amortization is a typical feature of an adjustable rate mortgage. Negative amortization happens when a variable-rate interest allows minimum payment options. A minimum payment option stands for making a payment on your mortgage in a particular month that is less than the interest owed. Since you are not even meeting the interest amount due on your mortgage in a month the lender adds the difference between your minimum payment and the full payment to the balance of your loan. The more minimum payments you make the more balance you add to your loan amount.
The minimum payment is usually set according to the start rate of the variable-rate mortgage. The start rate of a variable-rate mortgage is usually extremely low and can be as low as three to four per cent. This means that on a $200,000 loan at the start rate of 3.95 per cent the minimum option payment would be $949.07 per month. The full payment on the same amount at the rate of six per cent will be about $1199 per month. This creates a difference of $250 between the minimum payment and the fully indexed payment every month. For each month that you make a minimum payment lender will add $250 to the loan amount balance.
It is an equally obvious result that increasing the balance of your loan will increase the duration of the mortgage. If you could pay off the mortgage in about 30 years earlier, additional balance to the loan amount will require you to stay in the mortgage for a longer time. Since a regular and normal payments on a mortgage reduced the total term of the mortgage ( amortization period), the increase in the amortization period due to making minimum payments is called negative amortization.