Unlike a plain-vanilla fixed-rate mortgage, ARMs come with more jargon than most people would care to know. But it's vital to understand the index on which the rates are based, the margin amount and any interest rate caps (provisions in the contract that limit rate increases).
Index -- An index is a published measure of the cost of money. Lenders price home loans based on the index to which the loan will be tied. There are several different indexes lenders use to calculate the rate on ARMs. Some commonly used indexes are the one-year Treasury Constant Maturity, the London Interbank Offered Rate, or Libor, or the 11th District Cost of Funds Index, or COFI.
After the initial fixed-interest period, the rate will adjust based on predetermined agreements in your note.
"The lender will say, 'We will fix your interest rate at 4 percent for the next five years. At the end of five years, we will go out and find the value of one-year Treasury bills and add a margin to that and we will fix your interest rate on the loan for a year at a time based on that (index and margin),'" says Walters.
Margin -- The margin is a set amount that will be added to the index to determine the interest rate.
Cap -- The interest rate will adjust regularly, but there is a limit to the amount it can change. Typically, there will be a cap on the initial interest rate reset that is higher than all of the subsequent rate adjustments, and a cap on the amount the rate can change over the life of the loan.
"On the first adjustment with a lot of lenders, there is a 5 percent cap on the first reset and then it goes to 2 percent a year every year, with a lifetime cap of 5 percent over the starting interest rate," says Walters.
Interest-only loan
For those buyers who need a rock-bottom payment for several years, the interest-only mortgage product, as its name implies, allows them the option of paying only the interest for the first few years of the loan."You can pay principal if you wish; interest-only is an option," says Walters.
Interest-only loans are structured like an adjustable-rate mortgage.
"The most common one is the five-year fixed 30-year loan," says Klein. "The payment and interest rate are fixed for five years and the payment could be based on only the interest payment, so you're not paying down the principal. When it resets your payments can go up pretty significantly, even if the interest rate doesn't change that much."
An interest-only loan may be appropriate for homebuyers who believe their income will increase in the coming years -- for instance, young families or a professional just starting out at the bottom of a potentially lucrative field such as law or medicine.
"Who they are not good for is someone who is stretching every dollar to get into a house and whose income is going to be relatively flat," says Walters.
No matter what kind of loan gets you into a home, do your homework beforehand and make sure there are no details about the mortgage loan you don't understand.
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