Glossary

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Adjustable Rate Mortgage (ARM)

An ARM is a popular choice in mortgages today.  It offers a great opportunity to start with a lower interest rate on your mortgage, but you do run the risk of higher interest rates in the future.

An ARM has a lower initial interest rate than a fixed mortgage.  However, it only keeps this initial rate for a relatively short amount of time depending on what type of ARM you have.  Once that period is over, the interest rate of an ARM then goes up or down usually every year over the term of the loan.  You run the risk that interest rates can go up dramatically, causing your mortgage payment to sharply increase. 

The interest rate can change, or adjust, based on an index.  An index is a published interest rate against which lenders measure the difference between the current interest rate on an ARM and that earned by other investments.  For example, the lender can compare the current rate on the ARM with the monthly average interest rate on loans closed by savings and loan institutions.  Using this difference, the interest rate on the ARM is adjusted up or down.

An ARM does have a rate adjustment cap that limits the size of the initial rate adjustment and another cap that limits the size of subsequent rate adjustments. Caps refer to a legally required maximum on how much the interest rate of an ARM can increase over the life of the loan.  The overall cap limits the interest rate for the entire life of the loan.  The periodic cap limits how much the interest rate can increase at each adjustment period.  This means that your interest rate is not going to jump five points after one year.

Say the index rate rises 3 percentage points from 2.5 percent to 5.5 percent during an adjustment period.  That would make an interest rate of 4.5 percent rise to 7.5 percent.  However, a 2 percent cap would keep the interest rate at 6.5 percent.  This keeps the borrower from having too great a jump in his/her rate.

There are many types of ARM loan programs.  A standard ARM will adjust its interest rate annually for the life of the loan.  More popular ARM programs are the 3/1 and 5/1 ARMs.  These loans will hold its initial interest rate at a fixed amount for 3 or 5 years and then have a rate adjustment interval  every one year after that time.  Lender's may have many options varying the intial rate period and adjustment period to provide flexibility for the borrower based on their situation.

An ARM can be quite appealing.  Having the initial lower interest rate causes your mortgage payment to be lower at first.  If you know that you will move before your rates begin to change, an ARM may be right for you.  You can take advantage of the lower interest rates and move before the rates begin to change.  Also, if you know that you can refinance before the rates adjust, an ARM can be a good choice.  If you can either change the loan prior to the rate change or you know you will make enough in the future to handle a higher interest rate, an ARM can be a good choice.

However, you do need to carefully consider the consequences when deciding whether or not to get an ARM.  If interest rates are expected to drop for the foreseeable future, an ARM becomes more appealing.  If interest rates are expected to rise, an ARM becomes more costly.  An upcoming expense, such as a new car or student loan payment, can make an ARM more risky as you may have less money on hand to put towards your mortgage payment if there is a rate increase.  Also, if your job situation is not secure, an ARM can just be too risky.

When deciding whether or not to get an ARM, calculate the highest payment that you can afford without putting too much financial stress on yourself.  Figure out how high interest rates will have to go to reach that point.  If interest rates are likely to go that high, maybe an ARM is not for you.  If, however, you have some wiggle room and/or the chance to sell or refinance before that point, an ARM may be a good option to consider.

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