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Variable or Adjustable Rate Mortgage (ARM) is a mortgage loan whose interest rate, and accordingly monthly payments, fluctuates over the period of the loan. The interest rate changes at the predetermined period, called Adjustment Period (for example, every 1, 2 or 5 years). Depending on changing market conditions if interest rates go up, your monthly mortgage payment will go up, too, if rates go down, your mortgage payment will drop also. Periodic adjustments are based on changes in a predetermined defined index plus a predetermined fixed margin. The index as well as the fixed margin for a particular loan is established at the time of application.
The Index is typically set by market conditions. The most common indexes determining the periodic adjustments of the interest rate are:
- 12-Month Treasury Average
- 11th District Cost of Funds Index (COFI)
- Prime Rate
- Certificate of Deposit Index (CODI)
- London Inter bank Offered Rate (LIBOR)
- Constant Maturity Treasury Indexes (CMT) - 1-Year CMT,3-Year CMT, and 5-Year CMT
- Certificates of Deposit Indexes (CD) - 1-Month, 3-Month, 6-Month (most common)
Each ARM index has distinct market characteristics and fluctuates differently. CMT, COFI, and LIBOR indexes are the most frequently used.
The Margin is fixed percentage points added to the index to compute the interest rate. The result will then be rounded to the nearest one-eighth of a percent in most cases.
Example:
- The index is 4.8% and the margin is 2.5%
- The new interest rate = 4.8% + 2.5% = 7.3%
- The nearest to 0.3% is 0.25% = 2/8%.
- The result will be 7.25%
The margins remain fixed for the term of the loan and are not impacted by the financial markets and movement of interest rates. Lenders use a variety of margins depending upon the loan program, adjustment periods and the particular situation.
Most ARMs have an interest rate caps to protect you from enormous increases in monthly payments. A lifetime cap (interest rate ceiling) limits the interest rate increase over the life of the loan. It is the maximum rate that could be paid over the life of ARM. A periodic or adjustment cap limits how much your interest rate can rise at one time for the adjustment period.
Most ARMs have an interest rate floor to protect the lender from enormous decrease in monthly payments. . A lifetime floor limits the interest rate decrease over the life of the loan. It is the minimum rate that could be paid over the life of ARM. The lifetime floor is never lower than the margin. A periodic or adjustment floor limits how much your interest rate can drop at one time for the adjustment period.
Your mortgage disclosure will tell you the exact index to be used, whether the weekly or monthly value applies, the lead time for your index, the margin, any caps and floors.
Note: Make sure that you can afford the payment when rates are at the highest cap mark before accepting the loan.
It's very important to read carefully the mortgage disclosures!
- Benefits:
- The initial cost and interest rate will be lower for ARM than it will be for a fixed-rate loan.
- Warning:
- The rate can vary in an unpredictable manner, making planning difficult at best.
- Most ARMs are more difficult to understand.
Who should consider Adjustable Rate Mortgage (ARM) loans:
- Buyers who plan to refinancing their mortgage, or sell the home in the near future
- Buyers who expect their income to improve over the next few years and want a low start rate at the beginning
- Buyers who need a lower initial rate to afford to buy the home they want
- Buyers who believe interest rates will stay low for as long as they intend to keep the loan
Adjustable Rate Mortgage (ARM) Loans are:
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Some types of Adjustable Rate Mortgages offer payment caps rather than interest rate caps, which limits the amount the monthly payment increase. If a loan has payment cap but has no periodic interest rate cap, then the loan may become negatively amortized. This occurs when the combination of interest rates adjustments and payment caps result in a monthly payment that does not cover the interest portion of your loan. In this case, the difference would be added back to the total amount you owed on the loan, thus making a "negative amortization" to the mortgage.
Read more about Negative Amortization Mortgage Loans
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Convertible ARMs offer the borrower the option to convert the loan from an adjustable rate to a fixed rate at specified times during the term of the mortgage. This option is attractive to buyers who may wish to take advantage of current low interest rates, but want the security of a fixed rate mortgage in the future. The conversion is typically done for a nominal fee and requires almost no paperwork. The conversion interest rate is typically a little higher than the market rate at that time.
Read more about Convertible Adjustable Mortgage Loans
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Hybrid or fixed period ARMs allow you to secure the interest rate for a certain period of time before the initial interest rate changes. The payments are fixed for the predetermined fixed period. At the end of that period, your interest rate adjusts every year like a regular ARM according to a financial index (that's why some lenders call them 3/1, 5/1, 7/1 and 10/1 ARMs)
Read more about Hybrid ARMs
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Second Mortgage Loans have a signed second promissory note which is also secured by the property. Such loans are in addition to the first mortgage on the home. Usually, the loan is for a shorter period of time (15 years or less) and the rate is a little bit higher. Traditionally, second mortgage loans are offered with a fixed amount and a predetermined repayment schedule as well as some kind of prepayment penalties. The purpose of second mortgage loans could be home improvement, cash, education, debt consolidation, est. Often they are used to avoid Jumbo Mortgage Loan or for easier qualification.
Most common types are:
- Home Equity Loan (HEL):
Home Equity Loan is a loan that allows home owners to borrow against the equity in their property. Home equity loans usually have fixed interest rates and fixed payment amounts. The interest as well as the principle is included in the monthly payments and the loan is fully amortized.
Read more about Home Equity Loan
- Home Equity Line of Credit (HELOC):
Home Equity Line of Credit (HELOC) is a loan that allows homeowners to borrow against the equity in their property. HELOC usually have adjustable interest rates based on the Primary Rate (published daily in Wall Street Journal) plus or minus a margin. Payments may vary every month and the borrower may pay only the interest on the loan every month until the maturity of the loan. At the maturity day the borrower must repay the whole principle amount at once if there is any.
The Home Equity Line of Credit allows you to obtain cash advances with a credit card or to write checks up to the predetermined credit limit as often as you need. The credit line stays open even if you don't carry any principal balance until the predetermined loan period.
Read more about Home Equity Line Of Credit
Reverse mortgage is a mortgage loan program designed for seniors (62 and over). The reverse mortgage releases the home equity in the property either as one lump sum or in multiple payments. The homeowner's obligation to repay the loan is deferred until the owner lives, the home is sold, or the owner leaves the property (e.g., into aged care).
The common types of reverse mortgages are federally insured through the Department of Housing and Urban Development (HUD), Federal Housing Agency (FHA). Fannie Mae also offers reverse mortgages with a higher reverse mortgage limit. Several lenders and banks have their own reverse mortgage programs with a limit far above the maximum FHA 203(b) lending limit.
Read more about Reverse Mortgages
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