Understanding Adjustable Rate Mortgages (ARM)

What is an ARM?

An ARM is a loan whose interest rate can change during the loan's term. This type of loan usually has a fixed interest rate for an initial period of time and then can adjust based on current market conditions. An ARM typically offers a lower initial rate than a fixed-rate mortgage, so it allows borrowers to afford and purchase a more expensive home initially. It also amortizes over 30 years but with the initial period lasting anywhere from 1 month to 10 years.

How Does an ARM Work

All ARMs have two components, the "margin" and the "index." The margin is set by the lender and remains constant for the life of your loan. The index is determined by external economic factors such as inflation or Treasury bills rates and changes periodically based on these conditions. When your loan adjusts after its initial period, your new interest rate will be equal to the sum of these two components—the margin plus the index—and this will determine your monthly payments going forward.

Should I Choose an ARM Loan?

An adjustable-rate mortgage could be right for you if you plan on living in your home for fewer than 10 years or if you would like to take advantage of a lower initial rate in order to buy more house. Additionally, ARMs are good options if you think current interest rates may drop significantly during the life of your loan; however, keep in mind that there are risks associated with ARMs since they can go up as well as down in response to changing economic conditions.

Understanding Indexes and Caps

Indexes are used by lenders in order to determine the amount at which your ARM loan adjusts after the initial fixed-rate period ends. Common indexes include LIBOR, CMT, and Treasury Bills. It's important to understand how these indexes work in order to understand how much you will pay on your adjustable-rate mortgage after the fixed-period ends.
Caps are limits that lenders place on certain components of an ARM loan such as interest rates and monthly payments so that borrowers do not experience drastic changes in their payments due to sudden large increases or decreases in market conditions. There are two common caps: periodic caps, which limit how much your payment can change each time it adjusts; and lifetime caps, which limit how much your payment can go up over the life of the loan. It's important to understand these caps since they can protect you from large fluctuations in monthly payments due to changing market conditions.

Adjustable-rate mortgages (ARMs) are loans whose interest rate can vary during its term and depending on current market conditions. These loans usually have an initial fixed rate period followed by periodic rate adjustments based on current market conditions, allowing you to purchase more expensive homes than other types of loans such as fixed-rate mortgages might allow for within budget constraints.. Understanding how ARMs work—such as margins, indexes, and caps—is important if you're considering taking out one for financing purposes related to purchasing a new home or refinancing an existing one.