Types of Home Mortgages: Adjustable Rate Home Mortgage

The Adjustable Rate Mortgage Defined

The adjustable rate home mortgage—or ARM—is a complicated type of loan with several subtypes. In its most basic description, an ARM is a loan where the rate adjusts with economic indexes, which is a tool to calculate interest rates. Each different type of ARM uses a different index. Often you can choose your lender and loan type based on which index you wish to be used for your loan.

The Types of ARMs that are Available to You Today

First of all, your ARM will be named for its term; for instance, you may see a 2-1 ARM, a 3-2-1, a 5-1, and others. These are lengths of time, in years, that describe the interest rate changes. The first number is the beginning period, where your interest rate stays constant. The second numbers is the length of time over which new adjustments can be made by the lender. So in the 201 ARM, your initial rate will last for two years, then the rate can jump annually thereafter.

Your ARM and the Interest Rate

Remember that your beginning interest rate will be lower that the fixed rate mortgage interest rate. Because of the lower payment that results, you may be able to qualify for more of a loan, or it could help if you have a low down payment or plan to sell the home before the initial interest period has expired.

Rate Caps and Payment Caps

You should have two limits that come with your ARM—a rate cap and a payment cap. Although not all ARMs have them, the rate cap puts a limit on the amount that your interest rate can jump. The overall cap, which is provided for by law, limits the amount your rates can increase over the loan term. The payment cap limits the change in your monthly payment when your rate increases at the end of each rate period.

Beware of Negative Amortization

One thing to watch for when shopping for an ARM is the negative amortization. This happens when your payments can’t cover the cost of the interest, and this is tacked onto your loan. This means over time you will have a larger loan that you stared out with, and has been the heartache of many a homeowner.

You can avoid this by making sure your lender supplies you with enough information to make an informed decision. Ask questions—if they feel you’re a pest, go to someone who doesn’t. Negative amortization can have a devastating effect on your financial well-being.