Adjustable Rate Mortgages (ARMs)

ARMs offer borrower's two major benefits, First, if interest rates remain fixed or move lower, the adjustable rate loan could prove more economical for the borrower in the long-run. Second, lenders usually charge a discounted rate, which lowers the initial interest rate on the adjustable loan. Since the amount of the loan is determined on current income and first year payments, many borrowers can qualify for a larger loan.

There are also disadvantages to ARMs. Borrowers assume the risk of potential interest rate increases and higher monthly mortgage payments. ARMs, because of their nature, are occasionally subject to Negative Amortization., a situation where the limits on the monthly payment increases can prevent the mortgage payments from totally paying the monthly interest costs of the loan. In that situation, unpaid interest is added to the unpaid principal balance! With most mortgages, each payment will decrease the principal balance, eventually paying off the loan. In a situation of Negative Amortization, the unpaid principal balance actually increases, rather than continuing to decrease.

How Do ARMs Work?

There are several key elements which affect and impact the functioning of the ARM.

There are other elements which are involved in ARM adjustments.

Index-Look-Up-Date

The look-up-date is the exact date which the lender uses to determine the new index value when calculating a new interest rate for an ARM. The actual procedures for determining this date should be specified in the original loan agreement. This may initially seem a rather trivial consideration, however, when some indexes are published on a weekly basis, there is the possibility that a variation of even one day could change the index value, which in turn significantly changes the interest rate calculated.

Rounding the New Interest Rate

Many ARMs also feature provisions for the procedures to be used in rounding the New Interest Rate. There are two types of rounding procedures used most commonly.

Interest Rate Caps

Caps are frequently used in ARMs to prevent the interest rate on the loan from rising or falling too dramatically, either during the course of a single adjustment, or over the full term or life of the loan. Caps work to the advantage of both the borrower and the lender. There are two basic types of caps-Life (or Overall) Caps and Per Adjustment (or Periodic) Caps.

Payment Caps restrict the size of the increase in the monthly payment at each adjustment and are usually expressed as a percentage of the previous payment amount. Any applicable Payment Cap for the loan will be specifically stated in the original loan agreement. 

To summarize the above parameters regarding ARMs,

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