An adjustable rate mortgage (ARM) is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets.
The most important basic features of ARMs are:
- Initial interest rate. This is the beginning interest rate on an ARM.
- The adjustment period. This is the length of time that the interest rate or loan period on an ARM is scheduled to remain unchanged. The rate is reset at the end of this period, and the monthly loan payment is recalculated.
- The index rate. Most lenders tie ARM interest rate changes to changes in an index rate. Lenders base ARM rates on a variety of indices, the most common being rates on one-, three-, or five-year Treasury securities. Another common index is the national or regional average cost of funds to savings and loan associations.
- The margin. This is the percentage points that lenders add to the index rate to determine the ARM’s interest rate.
- Interest rate caps. These are the limits on how much the interest rate or the monthly payment can be changed at the end of each adjustment period or over the life of the loan.
- Initial discounts. These are interest rate concessions, often used as promotional aids, offered the first year or more of a loan. They reduce the interest rate below the prevailing rate (the index plus the margin).
- Negative amortization. This means the mortgage balance is increasing. This occurs whenever the monthly mortgage payments are not large enough to pay all the interest due on the mortgage. This may be caused when the payment cap contained in the ARM is low enough such that the principal plus interest payment is greater than the payment cap.
- Conversion. The agreement with the lender may have a clause that allows the buyer to convert the ARM to a fixed-rate mortgage at designated times.
- Prepayment. Some agreements may require the buyer to pay special fees or penalties if the ARM is paid off early. Prepayment terms are sometimes negotiable.