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Adjustable Rate Mortgages (ARMs) have become on of the most popular and effective tools for helping some prospective homebuyers achieve their dream of homeownership. Developed during a time of high interest rates that kept many people out of the housing market, the ARM offers lower initial rates by sharing the future risk of higher rates between borrower and lender.

ARMs can be an excellent choice of financing under certain conditions, such as rising income expectations, high interest rates, and short-term homeownership. But because payments and interest rates can increase, either steadily or irregularly, homebuyers considering this kind of mortgage need to have the income to keep up with all possible rate and/or payment changes. Each ARM has four basic components:

  • Initial interest rate, which is typically one to three percentage points lower than that of most fixed rate mortgages. Lower interest rates also make ARMs somewhat easier to qualify for. The initial interest rate is tied to certain economic indicators that dictate in part what the monthly payments will be.
  • Adjustment interval, at the time between changes in the interest rate and/or monthly payment will be.
  • Index*, against which lenders measure the difference between what they are making on their investment in the mortgage and what they could be making on other types of investments.
  • Margin, or the additional amount the lender adds to the index to establish the adjusted interest rate on an ARM. The margin is usually 1.5 percent to 2.5 percent.

In addition to the four basic components, an ARM usually contains certain consumer safeguards such as interest rate caps, which limit the amount that the interest rate applied to the payments may move. This prevents the amount of interest the consumer pays from rising higher than perhaps the homeowner can afford. For instance, a typical ARM would have a two percentage point cap over the life of the loan. That means that a loan with an initial interest rate of 9.75 percent would be able to go no higher than 14.75 percent over the life of the loan, and it would be able to move no more than two percentage points per year.

Another safeguard found on some ARMs are monthly payment caps that limit the amount homeowners need to increase their payments at adjustment time. Monthly payment caps can, however, sometimes prevent the monthly payments from increasing enough to keep up with the rise in the interest rate, causing negative amortization-resulting in higher or more payments for the homeowner later on.

Other options you should ask about when shopping for an ARM are:

  • Assumability, or whether you may transfer the mortgage to a new homebuyer, usually with the same terms if the new homebuyer qualifies for the loan. ARMs are almost always assumable.
  • Convertibility allows the borrower to change an ARM to a fixed rate mortgage, usually at the end of some predetermined period, locking in a lower interest rate.
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