Adjustable Rate Mortgage (ARM): How does it differ from FRM?

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Adjustable rate mortgage programs differ from fixed rate mortgages in several ways. First, ARM interest rates and monthly payments are subject to periodic adjustments or resets. Adjustable rate loans typically feature an introductory rate (sometimes called a "teaser") which is lower than the current rate for fixed rate mortgages. At the end of the introductory period, which can range from 3 months to ten years--the rate is reset. The new rate is calculated by adding the value of a financial index (such as the 1 year T-bill) to a margin set by the lender. Neither the lender nor the borrower has any control over the index, as the index reflects current financial markets. The new ARM rate, determined by adding the index and margin together, is called the fully-indexed rate.

Two other factors influence ARM rate adjustments: adjustment caps and lifetime caps. The adjustment cap limits the rate adjustment so that the borrower doesn't get hit with a huge payment increase all at once. They are often set at a maximum of 2 percent. So using this formula a loan with a rate of 4% cannot be increased to more than 6% when adjusted, even if the fully-indexed rate is 7.5%. To further protect the borrower, a lifetime cap limits how high the rate can go during the life of the loan. It may be expressed as a maximum rate or it may be expressed as a maximum increase. For example, the rate that began at 4% may have a life cap of 10%, or a maximum increase of 6%. That's just two different ways of denoting the same number.

Disadvantages:  Like fixed rate mortgages, ARMs also carry interest rate risk. For fixed rate borrowers the risk is that market rates will go down while their mortgage rate will stay up. For adjustable rate borrowers the risk is that market rates will increase and so will their mortgage rate. Borrowers who choose an ARM to take advantage of the introductory rate can find themselves in trouble if rates go up. This risk is greater for borrowers with little equity--they may find themselves unable to refinance to a new loan or sell the property because they owe too much. And if they made no provisions for making the higher payment the homeowners risk home foreclosure and badly damaged credit as well.

Advantages: Borrowers with ARM loans benefit when rates drop because their mortgage rates can fall as well. They don't need to refinance to get the lower rate. The lower initial rate can also help borrowers beginning their careers, letting them skip the "starter home" and buy a better house right away. The idea is that by the time the loan adjusts with possibly higher payments, the borrowers' income will have increased as well. They get the home they really want without the expense and hassle of selling a starter home, moving, and buying the nicer home.

Others take ARMs because they know the home will be sold before the loan's introductory period ends. The fully-indexed rate becomes irrelevant because the house is sold before the loan adjusts.

Some borrowers opt for ARMs to reduce the mortgage payment and temporarily free up cash for other investments. For example, someone starting a new business might want a lower house payment while the new company gets off the ground.

Another good use of an ARM loan is to accelerate paying down the mortgage and accrue equity faster. By applying the difference between a 30 year fixed loan payment and the lower ARM payment to the principal balance each month, the homeowner can build equity faster and create a financial safety net.

ARMs come with a wide range of features to suit the varying needs of borrowers, and they are not always easy to understand. The Federal Reserve has created a booklet called the Consumer Handbook on Adjustable Rate Mortgages (CHARM) that the lender can provide. It is also available online on the Federal Reserve Web site. The provisions of an individual loan are found on the Adjustable Rate Rider disclosure and on the Truth-in-Lending (TILA) disclosure. ARMs are powerful financing tools when taken for the right reasons and with full understanding.
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