Adjustable Rate Mortgage (ARM) Explained

Adjustable-rate mortgages were heavily sold by mortgage brokers and bankers the last 5 years and many borrowers looking for low payments eagerly signed the loan papers. At the time ARM mortgages offered low introductory interest rates and low payments for the borrowers the took them. The downside to all the ARM mortgages sold during that time is that from now through 2012 many homeowners will see their ARM mortgage rates will begin to adjust and their monthly payments will increase. At the time when ARM mortgages were being sold many homeowners did not understand the loan that was being offered to them, instead of asking the right questions many just signed the loan papers! Years later they are in for a big shock when the mortgage rate adjusts for the first time and their payment is hundreds of dollars higher then the month before! Many home owners will turn to refinancing to save them from increased payments and financial stress, but they should still understand the ARM mortgage they currently have. Not only will this help them determine the right time to refinance there existing ARM mortgage but also closely examine any of ARM program offered to them in the future.. Adjustable rate mortgages have their own language and terms that can confuse the potential borrower. Here are some key adjustable rate mortgage terms that you should know as a borrower. Use these definitions to your advantage when applying for your next mortgage.

1. Interest Rate Cap. The interest rate cap is the highest the ARM mortgage can adjust up to over the life of the loan.. Many of these caps are as high as 14% for a sub prime ARM

2. Periodic Cap. The periodic interest rate cap is the maximum the interest rate can increase or decrease at each adjustment period. An adjustment cap of 2% is common for most adjustable mortgages.

3. Loan Index. A number that is added to the margin of your adjustable mortgage to determine your interest rate. LIBOR is a common index that stands for the London Inter Bank Offering Rate. It is the average interest rate that London banks trade on deposits. Generally the LIBOR index is the most volatile, it can fluctuate the biggest amount and the most frequently.

4. Initial interest rate. This is the initial interest rate on the mortgage note. The introductory interest rate for ARM'S are generally much lower then a standard fixed rate mortgage. Your initial interest rate is locked in for a set period of time, generally 2-10 years. After that, it will adjust to the current rate which is arrived at by adding a Margin and Index.

5. Loan Margin. A margin is a constant numerical value that the lender adds to the index (LIBOR, MTA, COFI, etc.) associated with your adjustable rate mortgage in order to compute your interest rate. As the index value changes, so will your interest rate.

6. Rate adjustment. The act by a lender of changing the rate charged on an adjustable-rate loan. The loan contract specifies when the rate adjustment is made. The new rate is the combination of the index and a margin, subject to a periodic cap.

7. Loan Recast. Loan recast is specific to Pay Option or Pick a Pay type negative amortization ARMS. When the loan recasts the payment structure is reset so the loan is still paid in full at the end of the amortized time frame. Many pay option ARMS will recast at 5-7 years or when enough interest has been deferred that the loan balance is at 110-125% of the original loan amount

These terms should help the average borrower understand their adjustable mortgage a little bit better and plan accordingly. Although the ARM does have advantages the fixed rate mortgage is still the best for borrowers who intend to stay in their homes long term.

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