An ARM or an adjustable mortgage has a fixed rate of interest during the initial period of the loan. This initial period can range between one month and 7 or more years.
When the initial period expires, the interest rate will change. Note that borrower’s monthly payments can change even if the interest rates remain stable. While getting the loan, the borrower should know what the annual percentage rate or APR is. If the APR is much higher than the interest rate during the initial period, their payments will more than likely go up significantly when the loan resets.
The adjustment period
The adjustment period is the period between interest rate changes. Note that the interest rate can change every month, every three months, once a year, every three years, or every five years. If the adjustment period is one year, it’s called a one-year ARM.
Lenders determine the rate on an adjustable mortgage using two measures – the margin and the index. The index reflects the changes in interest rates. The margin is the extra amount the lender adds to the index to make profits. If the index goes up, the monthly payments will go up. If the index goes down, the payment too could go down. Note that some ARMs do not adjust downward. If that is the case, payments won’t decrease when the index rate decreases.
Lenders use different indexes. The most common among them are COFI, CMT, and LIBOR.
In order to determine a client’s interest rate, the lender should add a certain percentage to the index. This is called the margin. It can change from lender to lender. But it is unlikely to change during the life of a mortgage. The fully indexed rate is the index rate plus the margin
Low-Doc or No-Doc Loans
Lenders will usually ask for a borrower to submit proof of income. If they get a No-Doc loan, they do not have to show any proof. Of course, the interest rate will be higher.
The interest rate cap puts a cap on the percentage by which the interest can increase. By law, all ARMs now have a lifetime cap. Because of the interest rate cap, sometimes an increase in the rate is not imposed during an adjustment period. In this case, it may be carried over to the upcoming adjustment cycle. So, a payment may increase when the mortgage adjusts again even if the index hasn’t changed.
Besides interest-rate caps, some ARMs have payment caps. For instance, if the payment cap on a mortgage is 6%, the payment during one adjustment period can’t increase more than 6% over the previous payment. If the interest rate increases during this period, the lender will add any interest that you don’t pay your principal amount. This is what they call negative amortization. This can be a big trap for borrowers.
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