3. Adjustable-Rate Mortgages (ARMs):
Adjustable-rate mortgages (ARMs) have an interest rate that varies over time. The interest on a typical ARM adjusts every six to twelve months, but it may change as frequently as monthly. Other ARMs have an initial fixed rate for a period of time, after which the rate will adjusts annually. ARMs are tied to a number of indexes, which is a measure of general interest rate trends and is used to adjust the mortgage rate interest. The margin, also known as the spread, on an ARM is the markup, or profit, that the lender makes on the mortgage loan. This usually amounts to between 2 and 4 percentage points, but the exact margin depends on the lender and the index used.
Adjustable-rate mortgages (ARMs) have an interest rate that varies over time. The interest on a typical ARM adjusts every six to twelve months, but it may change as frequently as monthly. Other ARMs have an initial fixed rate for a period of time, after which the rate will adjusts annually. ARMs are tied to a number of indexes, which is a measure of general interest rate trends and is used to adjust the mortgage rate interest. The margin, also known as the spread, on an ARM is the markup, or profit, that the lender makes on the mortgage loan. This usually amounts to between 2 and 4 percentage points, but the exact margin depends on the lender and the index used.
The most common index for ARM adjustments is the one year U.S. Treasury bill. This is the interest rate that the government pays on some of its total debt. The most commonly used government interest rate indexes for ARMs are for six-month and twelve-month treasury bills. These tend to be among the faster moving indexes around, and therefore respond quickly to market changes in interest rates.
Often, people are attracted to an ARM because the initial interest rate tends to be significantly less than the interest on a fixed-rate mortgage. However, be skeptical of ARMs with initial interest rates that seem too good to be true. You will enjoy the artificially low interest rates for no more than six to twelve months, after which the interest rate will be adjusted according to the loan's index and margin.
Some Advantages of ARMs:
ARMs tend to start out at lower initial interest rates when compared to fixed-rate mortgages, and this may enable some people to qualify to borrow more. Also, because there is always the risk of rising interest rates with an ARM, lenders are more willing to give you a lower initial interest rate. This can result in considerable savings in the initial years of an ARM loan when compared to that of a fixed-interest rate mortgage.
Other advantages of an ARM is that if you purchase your home during a period of high interest rates, you can start paying your mortgage with the lower initial interest rate and hope that rates will fall in the future. In addition, if you do not plan on keeping your home for more than a few years, you can transfer your ARM to another buyer because some ARMs are assumable.
Rate Caps:
A good ARM offers built-in caps, also known as rate caps, that determine how high interest rates are allowed to rise. Three types of rate caps exist:
- Lifetime cap - Limits the highest rate allowed over the life of the loan. Never take an ARM without a lifetime cap, and be sure you can handle the maximum payment should it rise to the lifetime cap.
- Periodic rate cap - Determines the maximum rate change that your payments can rise or fall at each adjustment.
- Payment Cap - Offered in some ARMs, this cap limits the amount the payment can rise over the life of the loan.
In some instances, it may be possible to obtain an ARM that can be converted to a fixed-rate mortgage. Ask your lender.
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