Did you know what a ARM is?

Did you know what an ARM IS?
An ARM is an Adjustable Rate Mortgage.

The recent rise in interest rates has caused home buyers to take a closer look at adjustable rate mortgages, or ARMs. A key advantage to an ARM loan is that it usually has a lower initial interest rate than a fixed-rate loan, allowing a buyer to qualify either with a lower income or for a larger loan. In exchange for the lower rate, the home buyer must bear a greater amount of interest rate risk.

An ARM is a loan whose interest rate is adjusted according to movements in rates in the financial markets. The rate and the adjustments are determined by an index rate plus a margin. Suppose the current index rate is six percent and the margin is two percent. The interest rate used for calculating an ARM rate would be eight percent, which is the sum of the two. The index rate is usually some common measure of interest rates available regularly in the newspaper and on the Internet.

There are many different types of ARMs. Some maintain a fixed rate for up to 10 years before making any adjustments. Others may adjust the rate only one year or even one month after closing. Most ARMs have caps on how much the interest rate can increase in any adjustment period and/or over the life of the loan. The caps may be different at different points in the loan. For instance, an ARM that maintains the initial rate for five years may then adjust every year thereafter. The allowable increase after the first five years may be larger than the allowable increase in any of the later years.

ARMs with a long initial adjustment period are especially attractive to buyers who do not to expect to stay in a home long. If a buyer has an ARM with an initial adjustment period of five years and stays in the house for only four years, there will not be any adjustments on the loan. The buyer enjoys the advantage of the lower initial rate without ever having to experience possible rate increases.

As a rule, the greater the amount of interest rate risk borne by the home buyer seeking a loan, the lower the initial interest rate will be. For instance, an ARM that adjusts after one year and then every year thereafter is likely to carry a lower initial rate than an ARM which does not adjust until the end of the fifth year. The home buyer with the loan that does not adjust for five years is receiving greater interest rate security and pays for such security in the form of a higher initial rate.

ARMs can save a home buyer money should interest rates decline. With a fixed-rate mortgage, the only way to benefit from a drop in interest rates is to refinance the loan, which is expensive. With an ARM, a drop in mortgage rates might lower monthly payments without the need to refinance. So the thing to understand with an ARM the interest rate and drop or increase! Also remember that the period that the ARM adjust is generally 6 months to 1 year. Generally interest only loans are the only that adjust once a month.