Adjustable rate mortgage (ARM) loans are loans that have an interest rate that will fluctuate periodically. Unlike fixed rate loans where the interest rate remains constant through the life of the loan, adjustable rate mortgage loans will fluctuate based on the several indices of loan forecasting. Approximately 80 percent of all adjustable rate mortgage loans are based on one of these three indexes: 1) Constant Maturity Treasury (CMT) Indexes, 2) 11th District Cost of Funds Index (COFI) and 3) London Inter Bank Offering Rates (LIBOR).
Adjustable rate mortgage loans, compared to fixed rate loans, have a lower initial interest rate. They are a good option to consider if you’re only planning to own your home for a few years, you expect your future earnings to increase or the current interest rate for a fixed rate mortgage is too high. There is inherent risk with adjustable rate mortgage loans because often people are captivated by the low initial interest rate but never really budget for a period when the interest rates climb. Sometimes they get caught unable to meet the higher monthly payments when interest rates do rise and end up in default, losing everything.
Adjustable rate mortgage loans have four components to their structure: 1) an index, 2) a margin, 3) an interest rate cap structure, and 4) an initial interest rate period. After the initial interest rate period has ended, a new calculated interest rate becomes effective by adding a margin to the index. Since margins vary among lenders, it’s best to shop around for the lowest margin you can find. As the index moves up and down, as previously mentioned by the forecasting indices, your interest rate will rise or fall accordingly. Also, the rise and fall of your interest rate will be constrained by the interest rate cap structure of your loan.
The interest rate cap structure of your loan can provide you protection from wildly large interest rate swings. Adjustable rate mortgage loans have two types of caps: 1) annual, and 2) life-of-the-loan. The annual cap will restrict the interest rate change from going too far up or down in any given year. The life-of-the-loan cap will restrict the interest rate change from going too far up or down for as long as you have the mortgage.
As long as you are aware that adjustable rate mortgage loans can increase from their initial low rate they can be a good mortgage to have. However, if at the lowest interest rate you are paying as much as you can possibly ever pay for your mortgage, you are treading in dangerous waters. Many people are duped into this type of loan in predatory loan schemes where there is not full disclosure of the terms. When the initial interest rate period has ended and interest rates are high the mortgage loan payments become out of reach for some folks and they end up in foreclosure. Don’t let this happen to you.