Primary Elements of an Adjustable Rate Mortgage

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Man showing the house keyDuring your home buying journey, you will come across several types of home loans. Most people base their choice of a mortgage on what has worked for their friends and families in the past.

Mortgages are highly personalized loans and what works for one person might not work for another irrespective of the similarity in your finances and lifestyles. The two primary home loan categories available are adjustable or variable and fixed-rate mortgages.

The mortgage rates advanced by Guildford’s many lenders for an adjustable rate mortgage (ARM) alter over a loan’s lifetime depending on market conditions. There is a fixed rate period initially which can be one, three or five years after which the rate changes.

The initial rate your lender will charge is generally lower than that advanced for a fixed rate mortgage, and most people base their choice of an ARM on this. You should however asses all the elements of an ARM in totality to make a clear decision on whether or not this option will work for you.

The following are the primary elements of an ARM which should influence your choice.

Index

ARMs are tied to a particular index. This index will determine the behavior of your loan’s interest rate after the initial fixed rate period has expired. There are three indices generally used for ARMs including London Inter Bank Offering Rate (LIBOR), the prime rate, and the one-year Treasury rate.

The LIBOR is the most commonly used index since it allows the selling of mortgages on an international market. The prime rate index is generally used for HELOCs which allow you to draw on your home’s equity after some time.

Margin

Person giving bundles of cashYour lender will add particular percentage points to your loan’s index to determine your margin. This is the lender’s cost of business operations and their profits.

This margin is determined by a lender but generally range from 2–3.5% and is defined in your loan’s terms. It remains constant throughout your mortgage’s lifetime.

Cap or Limit

A cap is placed on how high an interest your lender can charge on your loan. This is an industry regulation to minimize the risk of a lender abusing an ARM by charging exorbitant rates.

The lifetime ARM cap, for instance, can be specified in your terms as a percentage of your overall indexed rate or as a stated number. Either way, you can plan your repayments around the cap rate since this is the highest interest rate which your lender can charge over your loan’s term.

Frequency of Adjustment

Your rate can be adjusted annually, bi-annually or after every two, three, five or seven years in an ARM. In general, your fixed period rates will be lower if you opt for a short adjustment period and vice versa. This is because your lender is cushioned from long-term losses in low rates from the frequent rate adjustment.

Some people shun ARMs because of the misinformation in various circles. If however you pay attention to and pick the best terms for the elements mentioned here, an ARM repayment will be hassle-free.

You will also take advantage of low repayments over certain periods and benefit from the flexibility and zero prepayment penalty an ARM offers.