Adjustable Rate Mortgage (ARM)
Also
known as a variable
rate mortgage. The interest
rate on these mortgages changes periodically.
Variable
or adjustable
loans are loans whose interest rate fluctuates over the period of
the loan.
TERMINOLOGY
Start rate (Teaser
rate):
This is the starting
interest rate of the variable. It is often referred to as the teaser
rate, since it is lower than the fully indexed
rate. This is often done to induce people into the loan since the
start rate is low.
Adjustment
Period :
This is the length of time for which the interest rate is fixed. Therefore
if the adjustment period is six months, then the interest rate will remain
fixed for six months, after which time it will adjust.
Adjustment
Cap:
This is the maximum the interest rate can adjust up or down each adjustment
period.
Lifetime
Cap:
The maximum interest rate over the life of the loan.
Index:
This is the variable that the rate is calculated from. This is normally
a number that is published in business newspapers. Well know indices include
:
Prime rate:
the rate offered to the bank's best customers.
Treasury
bill rate: Short term debt instruments used by the U.S. Government
to finance their debt. Commonly called Tbills
they come in denominations of 3 months, 6 months and 1 year.
Libor: London
Interbank Offered Rates. Average London Eurodollar rates.
6 month CD rate the average rate that you get when you invest in a 6 month
CD.
11th District Cost of Funds: Rate determined by averaging the cost of
money to banks that make the San Francisco 11th district of the Federal
Reserve.
Margin:
This is a fixed number added to the index to compute the actual rate.
Conversion
Options:
Some variable loans come with options to convert them to a fixed loan
based on a predetermined formula, during a given time period. For example
the 1year tbill adjustable may be converted to a fixed during the first
five years on the adjustment date. The means that you could convert during
the 13th, 25th, 37th, 49th and 61st months of the loan.
Computing
the mortgage rate:
The formula to calculate the new interest rate is
new
rate = index + margin
The
new rate is also influenced by the adjustment caps and the lifetime caps.
Examples:
If the old rate was 7%, and the new rate as calculated by the formula
is 9%, the actual new rate will only be 8% if the adjustment cap is 1%.
If the old rate was 7%, and the new rate as calculated by the formula
is 9%, but the lifetime cap is 7.5%, then the new rate will be 7.5%.
Fully
adjusted rate:
The fully adjusted rate is equal to the index + the margin. Example if
the index is 5% and the margin is 3% the fully indexed rate is 8%.
Popular Adjustable Rate Mortgage (ARM) Topics
