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Adjustable-rate Mortgage
An adjustable-rate mortgage (ARM), or variable-rate mortgage, is a mortgage loan with an interest rate that is adjusted periodically based on an index (prime rate). This is done to ensure a steady margin for the lender, whose own costs are usually related to the index. Monthly payments made by the borrower may change over time as the interest rate changes. This is not to be confused with the graduated-payment mortgage, which offers changing payment amounts but a fixed interest rate. Adjustable-rate mortgages trans- fer some of the interest rate risk from the lender to the borrower. The borrower benefits if the interest rate falls and loses if the inter- est rates rise.
All adjustable-rate mortgages have an adjusting interest rate tied to an index (prime rate). The index may be applied in one of three ways: directly applied, rate + margin, or based on index movement. A directly applied index means the interest rate changes exactly with the index. In other words, the interest rate on the note is the same as the index. These loans are usually reserved for borrowers with impeccable credit. A rate + margin basis means that the inter- est rate will equal the index plus a margin—additional percentage points added to the index. The amount of the margin may differ from lender to lender, but it usually stays the same for the length of the loan. The percentage of margin is stated in the loan papers. For example, the rate may be stated as Prime Rate plus 2%. The third calculation, index movement based, means the mortgage starts at an agreed-upon interest rate, which is then adjusted based on the movement of the index. The initial interest rate is not tied to any index; only the adjustments are tied to an index.
Example
Suppose you are interested in buying a home for $200,000. You have $20,000 down payment and you want a 30-year loan. Compare the monthly payments calculated by two different
Mortgage Loans 9