What is an adjustable rate mortgage loan?
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UPDATED: Oct 2, 2012
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An adjustable rate mortgage loan is home financing that has an interest rate that fluctuates in accordance to a pre-assigned market index. Adjustable rate mortgages are typically referred to as “ARMs.”
ARMs usually have a fixed-rate period at the beginning of their lifetime. This period is called the “teaser period” since an ARM’s early fixed-rates are lower than they’ll be when the loan begins to adjust. The teaser period exists in order to incentivize prospective borrowers to select ARMs over fixed-rate mortgages.
Following the teaser period—which may last anywhere from a few months to several years—the interest rate becomes subject to index fluctuations. Prior to even applying, a prospective borrower can view ARM interest rates since they are reported in mortgage loans news on a weekly basis.
The three indexes that rates are tied to are the Cost of Funds Index (COFI), the London Interbank Offered Rate (LIBOR), and the Treasury Bill or T-Bill Index. Once an index fluctuates, the mortgage loan lender will add a margin and recalculate the borrower’s new rate and monthly payment. As an index rate rises, the interest rate will rise. On the other hand, as an index rate falls, the interest rate will also fall. This process repeats each adjustment date, which usually occur once a year.
Some lenders offer interest-only ARMs. An interest-only adjustable rate mortgage loan requires a borrower to pay only the interest on their financing for a set period of time, such as 10 years. Following this period, the interest rate adjusts based upon a specified index. The mortgage loan then amortizes at a faster rate. However, during the interest-only payment period, borrowers can decide to pay some of the principal balance as well. This provides a great deal of monthly payment flexibility. As a result, interest-only ARMs are excellent choices for people that have variable monthly income.
Just in case some borrowers change their minds after borrowing an ARM, there is the option to switch to a fixed-rate mortgage. However, this conversion feature carries a fee.
Sometimes borrowers can transfer their ARM to another person. This is a common desire amongst borrowers who take an ARM in order to purchase a home to resell soon thereafter—such as what house flippers do. However, before transferring ownership of a loan, borrowers must speak with their lenders in order to find out if their financing is assumable. An assumable ARM allows a homeowner to sell a home to a homebuyer who then “assumes” the mortgage following qualification.
A more practical way of converting an ARM to a fixed-rate home loan is through a traditional refinance loan.