Understanding Your Adjustable Rate Mortgage (ARM) Program

Adjustable Rate Mortgages or ARMs are a popular financing vehicle for home financing. Despite this, many homeowners that currently have ARM financing really do not understand how their adjustable rate mortgage works. They may have a general understanding - that is after a specific period of time their rate could adjust due to open market conditions, but beyond this they have little or no understanding about their adjustable rate a mortgage.

Point in fact, not all adjustable rate mortgages are created equal, and their face value or designated name does not discriminate between these variances. This article will touch on the major points you should be aware of if you have an ARM home loan, but covering all aspects of adjustable rate mortgages is an impossible task to accomplish in a single post. For this reason here is a link to the CHARM handbook. CHARM is an acronym for Consumer Handbook on Adjustable Rate Mortgages, and is published by the Federal Reserve as a reference for consumers. This is not a short read, but does provide the information borrowers should be aware of if they are seeking an adjustable rate mortgage.

Considering not everyone has the time to review the CHARM handbook in its entirity, this post will touch on some of the major points of ARM home loans that everyone should be aware of if considering this type of financing solution.

Generally speaking most people are aware of the fact that different ARM programs offer different fixed periods. 1 month, 6 month, 1 year, 3 year, 5 year, 7 year, and 10 year are all types of adjustable rate mortgages. The first listed here however ( 1month, 6 month, 1 year) are not prevelant in the marketplace although they are available. Generally speaking ARMs are referred to by their fixed period - so they would be discussed as listed above. Looking for a 5 year adjustbale rate mortgage, most will refer to this program as a "5 year" or 5/1 ARM. This second designation is represented as a fraction. This second number (denominator) refers to the adjustment cycle. That is, when the rate does adjust in 5 years it will adjust once every year. Not all 5 year ARMs adjust once a year, some adjust twice a year which would be represented like this "5/6," the six representing the adjustment occuring every six months. All of the above programs mentioned are subject to this rule. Needless to say a 5/1 is more risky than a 5/6, and a 7/1 is more secure than a 5/1 (longer initial fixed period)... with this understanding we would assume a 5/1 ARM is a 5/1 ARM - this is not the case... ARM programs are identified by their initial fixed period but the details of each program vary. To understand this we must breakdown the interest rate.

Your interest rate for your ARM program is made up of two parts: the margin and the index. The margin can be thought of as the profit margin that rate offers the lender. This is a fixed figure that will not change throughout the course of the loan. Typical margins are in the range of 2.000% to 3.000% with 2.000% being a very good margin and 3.000% being a high margin. As I mentioned above the margin is a fixed number that will not change, it is static. The second part of the rate, the index, is ultimately what is responsible for adjustments in the adjustment phase of the home loan. There are many different indexes or indices (same word different spelling) that your ARM could be tied to, and all are different from one another. Well known indexes are the LIBOR, MTA, COSI, and PRIME. The important distinction between these indexes is the volatility. Certain indexes are more volatile than others. If the index of your adjustable rate mortgage is a volatile one, the chances of large adjustments is larger. Indexes that are more stable result in more moderate adjustments. Choosing an ARM with an index that you are comfortable with is important and something many people do not consider. Regardless this is an importnat aspect of your loan because it speaks directly to the inherent risk that loan carries.

So you know your index and margin, how do you determine your final rate? Simply add the index and margin together and you will have your home loan interest rate... well sort of. The final point we will be dicussing is caps. Caps again vary depending on the program. Not all 5/1 ARMs have the same caps. Caps refer to how much your rate can rise in any given adjustment and how high and low the rate can move. These caps are goingt to vary between lenders and are very important to discuss. If the caps at one lender are not favorable, it is reason enough to find another lender with more favorable caps. Think about it a 1% adjustment cap is very different than a 2% adjsutment cap or a 5% adjustment cap. They speak directly to exposure and future risk. If your rate can only adjust up a maximum of 1% per adjustment cycle... you have a much more secure program than than a program that allows for a 5% maximum adjustment.

Know your caps....

As mentioned above this is a genereal discussion of ARM programs, meant to inform borrowers about some of the finer details that many overlook. For a more thorough assessment of adjustable rate mortgages I highly recommend reviewing the CHARM handbook mentioned above.

In conclusion becuase there are so many varinaces between ARM programs, this is where brokers excel. A broker with significant lenders at their disposal will save you substantial time by going over these details before determining which lender is right for you.