Adjustable Rate Mortgage Interest Rate Changes
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How Does an Adjustable Rate Mortgage Interest Rate Change Work?
You should understand all the components of an adjustable rate mortgage (ARM) loan to be clear on how the rate calculations work. It may seem a bit confusing at first, but the math is pretty simple once you understand the process. Here are the components and how they work:
- Start Rate : The initial interest rate you receive at closing. It will remain constant per the terms of the loan until the first adjustment date. A one year ARM means the start rate will be constant for 12 months. A three year ARM mandates that the start rate will remain in effect for the first three years of the loan.
- Index : The third party rate used as the basis for interest rate adjustment calculations. The most popular of these are the U.S. Treasury Bill index, the LIBOR (London InterBank Offered Rate), and the 11th District Cost of Funds (COF) rate. These have been used for many years and normally have reasonably slow changes, which is good for you.
- Margin : The percentage that will be added to the Index at the adjustment periods to determine the new interest rate for the coming time frame. Margins vary widely, often from two to four per cent. On sub-prime loans, they can increase to five or six per cent.
- Adjustment Rate Cap : The maximum your interest rate can increase at any adjustment date. The most common adjustment rate cap has historically been two percent. You could find higher adjustment rate caps with three or five year ARM's since the rate is fixed for longer than the most common one year time frame. How does this work? If your current rate is 5.25% and your index and margin at the adjustment date add up to 8.00%, your maximum new rate would be 7.25% because of a two per cent rate cap.
- Lifetime Rate Cap : The maximum rate than can be charged over the life of the loan, regardless what the market rate may be. The most common life rate cap is six per cent. How does this cap operate? If your start rate was 5.25%, you can never pay more than 11.25% for the term of the loan, typically 30 years. If your loan has a two per cent adjustment cap, you could not reach your lifetime cap until at least the third adjustment period (e.g., four years in a one-year ARM, fifteen years in a three-year ARM, etc.)
There are more ARM products that might escalate your rate faster. A six-month ARM provides for two adjustment periods per year. ARM's that are “3/1” or “5/1” mean that your start rate is fixed for either three or five years BUT, after the first multiple year term, your rate will adjust every year
, not every three or five years. Obviously, you could reach your lifetime maximum much quicker than a classic three or five year ARM.
You can see why it is so important to understand all components of the ARM's you are considering. Once you do, you will be able to compare the varieties to determine which is best and most comfortable for you.