Understanding how Adjustable Rate Mortgages work before you borrow will help you avoid a disastrous mistake with your home loan. When evaluating Adjustable Rate Mortgages there are four factors you need to consider. Here are the basics of Adjustable Rate Mortgages you need to understand prior to applying.
There are four parts to every Adjustable Rate Mortgage. When considering an Adjustable Rate mortgage offer you need to pay close attention to the index, the margin, interest rate caps, and the adjustment period.
The Index your mortgage is tied to controls the interest rate. Most Adjustable Rate Mortgages are tied to the 1 year treasure index; although some are tied to the London InterBank Offered Rate or LIBOR index. Many lenders prefer the LIBOR index because the sell loans to European investors. There is not one index that is better than any other index although you may have a choice as to which index your benefit is tied to.
The margin is the markup your lender adds to the index when determining your mortgage rate. Margin is added to the index to determine your Fully Indexed Rate and set your monthly payment amount.
Margins range from 2 percent to as high as 2.75 so it is important to look at the margin when comparing loan offers.
The Adjustment period of your mortgage is the frequency that your lender raises or lowers your mortgage rate and payment amount based on the index. When the lender adjusts your loan they use the prevailing rate from your Index and add the margin. It’s possible your mortgage rate will remain unchanged; however, most often it will, taking your monthly payment amount with it. Common adjustment periods range from every six months to annually on the loan’s anniversary date.
The last of the four factors you need to consider when choosing an Adjustable Rate Mortgage are the rate caps. Caps reduce your risk when borrowing with an Adjustable Rate Mortgage by limiting the amount your interest rate and payment amount can change when the lender adjusts your loan. Periodic caps limit the amount the interest rate can go up or down and payment caps limit the amount the interest rate can change. It is important to ensure your Adjustable Rate Mortgage has both payment and periodic caps to protect you from negative amortization. Mortgages that experience negative amortization are actually growing over time instead of being gradually reduced as you make your payments. Both periodic and payment caps can also have lifetime caps that limit the total amount of change for both over the duration of your mortgage.
Finally, you may find an “initial cap” in your loan contract that specifies how much your interest rate will go up during the first adjustment. You can learn more about your Adjustable Rate Mortgage options, including costly mistakes to avoid with my free video tutorial.
My name is Rob Regehr and I’m a personal finance writer with a chip on my shoulder for banks and brokers that take advantage of my friends and neighbors.
