Adjustable Rate Loan

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Adjustable Rate Mortgage Loans: Open Your ARMs

Adjustable rate mortgage loans (ARMs) are mortgages in which the interest rate is adjusted periodically based on a pre-selected index. ARMs are generally defined in terms of an equation like 2/3/5 (explained below). To understand this kind of loan, here are the terms you need to know:
  • Index. The index is a published interest rate that serves as a general indicator of economic performance throughout the country. Lenders use the index to measure the difference between the current interest rate on your adjustable rate mortgage and the interest earned by other kinds of investments, such as U.S. Treasury yields and loans held by other institutions. This difference is then used to adjust the interest rate on your mortgage up or down.
  • Margin. This is the amount a lender adds to your adjustable rate mortgage, in addition to the index, to establish the adjusted interest rate. The margin is one of the most important aspects of an ARM because it is added to the index to determine the interest you will pay. The margin added to the index is known as the "fully indexed rate." For example: if the current index value is 5.50% and your loan has a margin of 2.5%, your fully indexed interest rate is 8.00%.
  • First Adjustment Cap. The percent that the interest rate will change after its initial fixed period. For example, a loan that will change from its initial 6% rate to 8% has a first adjustment cap of 2%. This is the first number in the standard ARM equation of 2/3/5.
  • Adjustment Cap: The maximum percentage that the interest rate can increase each time. For example, if the interest rate can only adjust 3 percent on each adjustment after the first, then our second number is 3, making the equation 2/3/5.
  • Life Cap: The maximum percentage that the interest rate can rise to. For example, if the life cap on the loan is 11% and the initial interest rate is 6%, then the loan will never go up more than 5% total after that, giving the third number in our example: 2/3/5.
Sheryl Landrum, Senior Loan Officer, First Capital Mortgage of San Diego, Bonsall, CA.
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