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LESSON 4: TYPES OF LOANS -- ADJUSTABLE-RATE MORTGAGES
(ARMs)
Adjustable-rate
mortgages, or ARMs, differ from fixed-rate mortgages in that
the interest rate and monthly payment moves up and down as market
interest rates fluctuate. Most have an initial fixed-rate period
during which the borrower's rate doesn't change, followed by a much
longer period during which the rate changes at preset intervals.
The rates charged during the initial periods are generally lower
than the rates found on comparable fixed-rate mortgages. After all,
lenders have to offer borrowers something to make it worth their
while to assume the risk of higher rates in the future!
The initial fixed-rate period can be as short
as a month or as long as 10 years. One-year ARMs are the most common,
though so-called hybrid
ARMs have become more popular in recent years. These hybrid
ARMs -- sometimes referred to as 3/1, 5/1, 7/1 or 10/1 loans --
have fixed rates for the first three, five, seven or 10 years, followed
by rates that adjust annually thereafter.
Adjustable-rate mortgages (ARMs) are favorable
when rates are going down or your salary is going up. Otherwise,
each rate adjustment can sting. |
After the fixed-rate honeymoon, an ARM's rate
fluctuates at the same rate as an index spelled out in closing documents.
The lender finds out what the index
value is, adds a margin
to that figure, then recalculates what the borrower's new rate and
payment will be. The process repeats each time an adjustment date
rolls around. See
Tip 1
Borrowers have some protection from extreme
changes because ARMs come with caps.
These caps limit the amount by which ARM rates and payments can
adjust at any given milestone. See
Tip 2
(continued on next page)
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