Definition of "Adjustable Rate Mortgage (ARM)"
Also called variable or flexible rate mortgage, an adjustable rate mortgage (ARM) is a mortgage where the interest rate is not constant, but changes over time by the mortgage lender.
Adjustable Rate Mortgages (ARM) often have attractive beginning interest rates, called teaser rates, and monthly payments. However, there is the risk that payments will increase.
While Adjustable Rate Mortgage (ARM) contracts in many countries abroad allow rate changes at the lender's discretion, in the U.S. rate changes on Adjustable Rate Mortgages (ARM) are mechanical. They are based on changes in an interest rate index over which the lender has no control.
Reasons for Selecting an Adjustable Rate Mortgage
Borrowers may select an Adjustable Rate Mortgage in preference to a fixed rate mortgage (FRM) for three reasons:
- To qualify: they need an Adjustable Rate Mortgage to qualify for the loan they want.To qualify: they need an Adjustable Rate Mortgage to qualify for the loan they want.
- To take advantage of low initial rates on Adjustable Rate Mortgages and their own short time horizon: they expect to be out of their house before the initial rate period ends.
- To gamble on future interest rates: they expect that they will pay less on the Adjustable Rate Mortgage over the life of the loan and are prepared to take the risk that rising interest rates will cause them to pay more.
How to determine the Interest Rate on an ARM
There are two phases in the life of an Adjustable Rate Mortgage. During the first phase, the interest rate is fixed, just as it is on a Fixed Rate Mortgage (FRM). The difference is that, on an FRM, the rate is fixed for the term of the loan, whereas on an ARM it is fixed for a shorter period. That period can range from one month to 10 years, and, at the end of the initial rate period, the ARM rate is adjusted. The adjustment rule is that the new rate will equal the most recent value of a specified interest rate index, plus a margin.
For example, if the index is 5% when the initial rate period ends, and the margin is 2.75%, the new rate will be 7,75%.
This rule, however, is subject to two conditions. The first condition is that the increase from the previous rate cannot exceed any rate adjustment cap specified in the ARM contract. An adjustment cap, usually 1% or 2% - but ranging in some cases up to 5% - limits the size of any interest rate change. The second condition is that the new rate cannot exceed the contractual maximum rate. Maximum rates are usually five or six percentage points above the initial rate.
During the second phase of an Adjustable Rate Mortgage life, the interest rate is adjusted periodically. This period may or may not be the same as the initial rate period. For example: an ARM with an initial rate period of five years might adjust annually or monthly after the five-year period ends.
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