Adjustable Rate Mortgage: Terminology And Benefits

Adjustable Rate Mortgage (ARM) is basically a home loan with variable interest rate; the rate gets adjusted with the changes in interest rate in the marketplace. The interest rate on your mortgage remains fixed for a certain time period after which it gets changed periodically. The monthly mortgage payments increase with the rise in the market interest rate. Therefore, you need to understand the ins and outs of ARM before opting for it.

ARM terminology

Before proceeding with the characteristics of Adjustable Rate Mortgage, it is quite essential to understand some of its important terms and concepts, which are discussed below.

• Index: The interest rate measurement (or, index) to which the ARM gets adjusted. As for example, a 2-year Treasury ARM will get adjusted on the basis of the yield of 1-year Treasury bill, which is a government debt security.

• 5/1 ARM, 10/1 ARM, etc.: The first number denotes the number of years in the initial fixed period and the second number indicates the time period for which the new adjusted rate will remain in effect.

• Margin: The amount of percentage points that are added to the index in order to compute the ARM rate.

• Full index rate: It refers to the rate with which the lenders calculate an ARM payment. It is obtained by adding its margin to the index.

• Prepayment penalty: It refers to the fees that you may have to pay as a penalty if you repay your mortgage before completion of its loan term.

• Caps: The ceiling (maximum interest rate) and floor (lowest interest rate) that restricts the change in the interest rate in a given time period. MostARMs have annual adjustment cap (that limits yearly changes) along with a lifetime cap (that limits change over the entire loan term).

Types of ARMs

There are 3 types of ARMs as discussed below.

1. Interest-only ARM: You need to pay only the interest rate for a given period after which your monthly payments increase even if your interest rate remains fixed.

2. Hybrid ARM: In this type of mortgage, the interest rate remains fixed for a certain time period after which the rates change at regular intervals.

3. Pay Option ARM: It permits you to choose from a variety of payment options, such as, interest-only payment, minimum payment plan, fully amortized payment plan, etc.

Types of indexes

Out of the different types of indexes, lenders usually choose an index while offering you an Adjustable Rate Mortgage, after the initial fixed rate period is over, your mortgage interest rate will vary depending upon the specific index that your lender has selected.

Some of the common indexes are:

• Treasury Bill (T-Bill)

• 11th District Cost of Funds Index (COFI)

• Certificate of Deposit Index (CODI)

• London Inter Bank Offering Rates (LIBOR)

• Cost of Savings Index (COSI)

Benefits of ARM

Adjustable Rate Mortgage offers a number of benefits as listed below.

• If you opt for an ARM, then you have a higher chance to qualify for a home loan.

• It is ideal if you’re planning to relocate after a few years.

• The interest rate may decrease thereby lowering your monthly mortgage payments.

Apart from the above benefits, the initial monthly payments are comparatively lower in case of ARM; it helps you to save a substantial amount with which you can repay other loans. However, there are certain pitfalls of Adjustable Rate Mortgage, the principal one being the increase in monthly payments with the rise in interest rate. So, carefully examine your financial status before opting for an ARM.