Before deciding on an ARM, you need to consider how long you will own the property and how often your monthly payment may change, as well as the components of the ARM (discussed below).

Why choose an ARM?

The low interest rates offered by ARMs make them attractive alternatives to fixed rate mortgages during periods when interest rates are high, or when you only plan to stay in your home for a relatively short period of time. Often times, you will find it easier to qualify for an ARM over a traditional home loan, because a lower interest rate typically results in a lower monthly payment, resulting in lower qualifying ratios (see Additional Info: How Much Home Can You Afford?). However, ARMs are not for everyone. If you plan to stay in your home for a long period of time or you are hesitant about having your monthly payments change from time to time, then you may prefer the stability that a fixed rate mortgage offers.

Components of ARMs

Adjustable rate mortgages have three primary components that you need to consider: an index, a margin and the calculated interest rate.

· Index The interest rate for an ARM is based on an index that measures the lender’s ability to borrow money. While the specific index used may vary depending on the lender and the specific type of ARM (for example, conventional vs. FHA), some of the more common indexes used include U.S. Treasury Bills and the Federal Housing Finance Board’s Contract Mortgage Rate. One thing all indexes have in common is that they cannot be controlled by the lender; therefore, changes in the index will result in corresponding changes in the interest rate of the ARM, which will translate into changes in your monthly mortgage payment (either up or down).

· Margin The margin (also known as “the spread”) is a percentage added to the index to cover the lender’s administrative costs and profit. Though the index may rise and fall over time, the margin usually remains constant over the life of the loan.

· Calculated Interest Rate The calculated interest rate, which is the rate you pay for your mortgage, is derived by adding the index and the margin together. It is also the rate to which an future rate adjustments will apply.

Adjustment Periods and Teaser Rates

Because the interest rate for an ARM may change because of economic conditions, a key factor to ask your lender about is the adjustment period (or how often the rate may change). Many ARMs have one-year adjustment periods, which means the interest rate and monthly payment are recalculated (based on the index) every year. Depending on the lender and the type of ARM, shorter or longer adjustment periods are available.

An ARM can also have an initial adjustment period based on a “teaser rate” – an artificially low introductory interest rate offered by a lender to attract homebuyers. Typically, teaser rates are only good for a short period of time (for example, 6 months or a year), after which the loan reverts back to the calculated interest rate. A key note to remember is that most lenders will not use the teaser rate to qualify you for the loan. Instead, they will use a 7.5% interest rate (or calculated interest rate, if it is lower).

Rate Caps

To protect borrowers from dramatic rises in interest rates, most ARMs have “rate caps” that govern how much the interest rate can rise between adjustment periods, as well as how much the rate may rise (or fall) over the life of the loan. For example, an ARM may be said to have a 2% periodic cap and a 6% lifetime cap, meaning that the interest rate can rise no more than 2% during an adjustment period, and no more than 6% over the life of the loan. Typically, a lifetime cap applies to the calculated interest rate, rather than an introductory or teaser rate.

Payment Caps and Negative Amortization

Some ARMs also offer payment caps, which differ from rate caps. Payment caps place a ceiling on how much your payment can rise during an adjustment period. While this may sound like a good thing, it can sometimes lead to trouble.

For example, what happens if the interest rate cap rises during an adjustment period, resulting in additional interest due on the loan payment in excess of what the payment cap allows? This situation creates what is referred to as “negative amortization”. Because the payment cap does not allow for collection of all of the additional interest that resulted from the rise in the interest rate, the balance due on your loan will actually increase, even though you continue to make the minimum monthly payment.

Many lenders limit the amount of negative amortization that may occur before the loan must be restructured. It’s always a good idea to speak with your lender about payment caps and how negative amortization is handled.

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