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Adjustable Rate Morgage Definition & Information
The Adjustable Rate Morgage is a type of loan where the interest rate changes periodically in relation
to an Index (see the list of Adjustable Rate Morgage Indexes below) and, because of this, the monthly
payments rise and fall accordingly. Although monthly payments do fluctuate with this type of loan there
are Periodic Caps' and 'Lifetime Caps' to protect consumers from drastic fluctuations. (See 'Periodic Caps'
and 'Lifetime Caps' below).
PERIODIC CAPS AND LIFETIME CAPS:
Although the interest rate may rise and fall in relation to the Index there is still
a limit on the amount it may rise and fall. These limits are called 'periodic caps' and 'lifetime caps'.
The Periodic Cap is a limit on the amount a rate or payment can increase during a given period. For example,
the Periodic Cap may be 1% a Year; this means that in no circumstances can your payments be based on a rate
that is more than 1% higher than your rate was in the previous 12 months. The Lifetime Cap sets a limit on
the amount the rate can increase to at any point in time. For example, a loan with a Lifetime Cap of 11% can
never increase beyond 11% even if the Margin and Index dictate a higher rate than 11%.
The monthly payments are based on what is referred to as the 'Fully Indexed Rate'. The Fully Indexed Rate is
comprised of a selected Index (see the list of Indexes below) and a 'Margin' that is added to the Index. The
Margin is a fixed percentage whereas the Index fluctuates on a monthly basis. Again, you couple the fixed
'Margin' with the fluctuatint 'Index' to get the 'Fully Amortized Rate'. The Index is generally considered the
considered the (bank's) cost of borrowing money in the current market whereas the Margin is the amount a
bank adds to this cost of borrowing money in order to cover operating expenses and profit. In fact,
it is this guaranteed profit that permits lenders to offer Adjustable Rate Morgage products for less than
Fixed Rate products. The reason is that such a loan can always be sold on the 'secondary market' to a new
lender and this new lender will profit regardless of current rates.
Many people choose Adjustable Rate Morgages on account of the lower interest rates. Also,
the lower payments permit some people to qualify that would otherwise not be able to do so (because a lower
monthly payment reduces a borrower's 'Debt to Income Ratio'). Another reason
people select these types of loans is because you do not need to refinance to take advantage of dropping rates
because your rate automatically decreases in synch with the market. So if you believe rates will be dropping
over the next few years this type of loan can save significant refinance costs.
Please note that the common Adjustable Rate Morgage amortization term is thirty years. It should also
be noted that, as a rule, the fixed interest rate initially offered by these programs is higher the longer
the fixed period is. For example, a Seven Year Arm generally has a higher rate than a Five Year Arm.
ONE YEAR ADJUSTABLE RATE MORGAGE: This product offers an interest rate that is fixed for a one-year period and, thereafter,
goes to the 'Fully Indexed Rate' (which can be higher or lower than the rate which had been fixed)
and adjusts accordingly.
TWO YEAR ADJUSTABLE RATE MORGAGE: This term is most commonly offered by Subprime lenders. The interest rate
is fixed for twenty-four months and then begins to adjust according to a 'reset schedule'. For those with
less-than-perfect credit it offers sufficient time to repair their credit with a more affordable payment
than would be offered by a thirty year fixed Subprime loan.
THREE YEAR ADJUSTABLE RATE MORGAGE: This rate is fixed for a period of three years and, after that,
it goes to the 'Fully Indexed Rate' (which can be higher or lower than the rate which had been fixed)
and adjusts accordingly. The periodic adjustment is referred to as the 'reset'.
FIVE YEAR ADJUSTABLE RATE MORGAGE: This rate is fixed for a period of five years and, after that,
it goes to the 'Fully Indexed Rate' (which can be higher or lower than the rate which had been fixed)
and adjusts accordingly. Note: the rate generally resets monthly for three, five, seven and ten year arms
but there are some programs wherein the Reset Schedule dictates that the rate be reset every six months.
SEVEN YEAR ADJUSTABLE RATE MORGAGE: This product offers a fixed rate for the first seven years and then
begins resetting based on the 'Fully Indexed Rate' (which may be higher or lower than the rate was for the
fixed period). History shows that this option usually has a rate just a bit below that of the thirty
year fixed and a little higher than that of the Five Year ARM.
TEN YEAR ADJUSTABLE RATE MORGAGE: This loan has an initial fixed rate for the first ten years and, thereafter,
resets according to the 'Fully Indexed Morgage Rate'. Throughout the immediate history the rate for this
program is usually identical to that of the thirty year fixed and slightly higher than that of the
Seven Year ARM
POPULAR MORGAGE INDEX LIST
Prime Rate: This is the average interest rate banks charge their preferred customers, the average of which
is published monthly in the Wall Street Journal
COFI: The 'Cost of Funds Index' is a very stable index derived from the average cost of deposits and
borrowings as recorded by the savings institutions in the Federal Home Loan Bank's 11th District. This
district consists of California, Nevada and Arizona.
CODI: The 'Certificates of Deposit Index' is the 12-month average of the monthly average yields of
3 month certificates of deposit. This rate is published monthly by the Federal Reserve and, on account of
it being a 12-month average, it is more steady than strait CD rates.
CMT: Constant Maturity Treasury Index is the weekly average yield on the United States Treasury securities
adjusted to a constant maturity of 1 year.
MTA: This is based on the same securities as the CMT but it is based on annual yields rather than weekly
yields. Because of that it is also known as the 12 MAT or the 12 MTA.
LIBOR: The 'London InterBank Offering Rate' is the average lending rates from a number of major banks based in
London, England. It is commonly used as an international interest rate index. Note that there are literally
hundreds of LIBOR rates published each month in numerous currencies. U.S. LIBOR morgages are based on the
rate as published monthly by Fannie Mae.
NOTE: MANY ADJUSTABLE RATE MORTGAGE PROGRAMS (SUCH AS OPTION ARMS, HYBRID ARMS AND PICK-A-PAY ARMS)
HAVE SEVERAL PAYMENT OPTIONS INCLUDING:
1) INTEREST ONLY OPTION
2)INTEREST AND PRINCIPAL AMORTIZED OVER 30 YEARS
3)INTEREST AND PRINCIPAL AMORTIZED OVER 15 YEARS
4) NEGATIVE AMORTIZATION OPTION (Neg-Am).
* Ask your morgage consultant to explain these options in detail
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Adjustable Rate Morgage Definition, Advice, Information and Current Rates
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