Adjustable Rate Mortgage (ARM) Explained

Mortgage brokers and bankers have sold a lot of adjustable rate mortgages in the last 5 years and many borrowers looking for low payments enthusiastically signed the loan documents. At the time, ARMs offered low introductory interest rates and low payments for borrowers who took them. The downside to all the ARMs sold during that time is that between now and 2012, many homeowners will see their ARM rates start to adjust and their monthly payments go up.
At the time ARMs were being sold, many homeowners did not understand the loan being offered to them, instead of asking the right questions, many simply signed the loan documents! Years later, they’re in for a big scare when the mortgage rate adjusts for the first time and their payment is hundreds of dollars higher than it was the month before. Many homeowners will turn to refinancing to save themselves from higher payments and financial stress, but they still need to understand the ARM they currently have. Not only will this help them determine the right time to refinance the existing ARM, but it will also closely scrutinize any ARM programs that are offered to them in the future.
Adjustable rate mortgages have their own language and terms that can confuse the potential borrower. Here are some key adjustable rate mortgage terms you should know as a borrower. Use these definitions to your advantage when applying for your next mortgage.

1. Maximum interest rate limit. The interest rate cap is the highest the ARM can be adjusted to over the life of the loan. Many of these limits go as high as 14% for a subprime ARM

2. Periodic limit. The periodic interest rate cap is the maximum that the interest rate can increase or decrease in each adjustment period. A 2% adjustment cap is common for most adjustable mortgages.

3. Loan ratio. A number that is added to the margin of your adjustable mortgage to determine your interest rate. LIBOR is a common index that represents the London Interbank Offered Rate. It is the average interest rate that London banks trade on deposits. Generally the LIBOR index is the most volatile, it can fluctuate more and more frequently.

4. Initial interest rate. This is the initial interest rate on the mortgage note. The introductory interest rate for ARM’s is generally much lower than a standard fixed rate mortgage. Your initial interest rate is locked in for a set period of time, usually 2 to 10 years. After that, it will be adjusted to the current rate which is arrived at by adding a Margin and an Index.

5. Loan margin. A margin is a constant numerical value that the lender adds to the index (LIBOR, MTA, COFI, etc.) associated with your adjustable rate mortgage to calculate your interest rate. As the value of the index changes, so will your interest rate.

6. Rate adjustment. The act by a lender of changing the rate charged on an adjustable rate loan. The loan agreement specifies when the rate adjustment is made. The new rate is the combination of the index and a margin, subject to a periodic cap.

7. Refunding of loans. Loan recast is specific to Pay Option or Pick a Pay type negative amortization ARMS. When the loan is modified, the payment structure is reset so that the loan is still paid in full at the end of the amortized time period. Many ARMS payment options will reformulate in 5-7 years or when enough interest has been deferred to bring the loan balance to 110-125% of the original loan amount.

These terms should help the average borrower understand their adjustable mortgage a little better and plan accordingly. Although the ARM has advantages, the fixed-rate mortgage is still best for borrowers who intend to stay in their homes long-term.