Adjustable Rate Mortgages: Your Rate is
Tied to an Index
known as ARMs, differ from fixed-rate mortgages in that the interest rate
moves up or down. ARMs are tied to a number of indexes, which usually are
published interest rates. The margin is the amount a lender adds to the
index, usually two percentage points or four percentage points, to set the
actual interest rate of the ARM.
The most common index for
ARM adjustments is the one-year U.S. Treasury bill. The one-year bill has
a yield very near that offered by the 30-year Treasury bond, which is used
to set rates on 30-year fixed mortgages.
The initial ARM rate is
generally lower than the fixed mortgage rate, though in the current
economy the one-year ARM rate has been only slightly lower, about
one-quarter to one-third of a percentage point. Check out the latest
bankrate.com survey of ARM
an ARM For You?
If you plan to be in the house for less than five years, it may be worth
paying the lower interest rate on an ARM vs. a fixed-rate mortgage.
It may be worth investing
the difference between an ARM payment and a fixed loan payment in mutual
funds and other investment securities.
If mortgage interest rates
are high, you can get a lower rate to start with and hedge your bet that
rates will fall in the future.
Facts About ARMs
There are varieties:
Some ARMs adjust the
interest rate every year, while others have an initial fixed rate
period of 3, 5, 7 or even 10 years, after which the rate adjusts on an
The more short term the
index that your ARM is tied to, the more volatile your payments will
be. That's good if interest rates fall, but it can cause trouble if
interest rates rise.
Most ARMS offer built-in
caps to protect against enormous increases in payments:
Limits how much the interest rate can rise during the life of the
Periodic rate cap
Limits how much your payments can rise at one time.
Payment cap Offered
in some ARMs, it limits the amount the payment can rise over the life
of the loan. So if the underlying index rises, your payment would
increase only to the limit of the payment cap.
Keep in mind that rate caps
work when the rates rise and when they fall. To get a better
understanding of how ARMS work, we compare adjustable and fixed-rate
mortgages in the next section.
To keep your financial options open, make sure to ask the mortgage lender
if the ARM is convertible to a fixed-rate mortgage. Also, ask if the ARM
is assumable, which means when you sell your home the buyer may qualify to
assume your existing mortgage. That could be desirable if mortgage
interest rates are high.
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