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Your Options With Adjustable Rate Mortgages

Oct 31, 2007
Adjustable rate mortgages, also called ARMs, are a useful kind of mortgage for people in certain situations. Their set terms and plans can help you decide what kind of loan to get when you buy a new home or refinance your existing one.

An ARM provides flexibility, changing throughout the term of your mortgage. These changes are dependent on prevailing interest rates, and the guidelines and requirements of your lender. Generally, it starts at a lower rate than a traditional mortgage, then will fluctuate throughout the term of your loan. If you'd like to get this kind of mortgage, remember to consider several factors.

An adjustable rate mortgage is based on the idea of being able to have lower mortgage payments compared to a fixed rate loan. This means that mortgage lenders can offer lower prices to those who might not ordinarily be able to afford one. The rate will stay the same over a predetermined period, then change afterwards. How long this period is will depend on your individual loan. It can be anywhere from a month to a decade. Remember to consider how long you're planning to keep your home when you calculate how the period of your fixed rate will affect you.

The second part of this kind of a loan is called the index, which is tied to the prevailing interest rate. This helps to determine the adjusted rate of the mortgage. Indexes can come from a few different sources, including the 12 MTA, a one year treasury guide, the LIBOR, or London Interbank Offering Rate, updated every one to six months, the Cost of Funds Index (COFI), Cost of Savings Index (COSI) or Cost of Deposit Index (CODI.) These latter indexes are prone to more fluctuation than the former. The last way to find an index is by using the prime bank rate. However, these are mostly for home equity credit lines.

Indexes work through each set index having a margin. This margin will determine your interest rate after your fixed period ends. Margins vary wildly, depending on the index you use and the lender you're with. By referring to the margin, it's possible to tell what percentage of the adjustable rate you'll have to pay. If you know what index your lender uses, you can predict the interest rate on your adjustable rate mortgage.

The third part of an Adjustable Mortgage is called a cap. This restricts how much your rate can change and is usually no less than two percent, but no more than six percent. This prevents extreme fluctuation in your interest rates without warning. Some also have starting rates, which differ depending on the lender and index, and can also be affected by your credit score and the amount of your up front deposit.

This variety of funding can help by offering four different kinds of payments, each based on a cap and index. The first kind is a minimum payment option and is the lowest of all. It doesn't pay either the principle or all of the interest. Unpaid interest is placed into a category called interest cut, which increases the amount you'll eventually have to pay. This is called negative amortization or deferred interest.

An interest only payment will allow you to pay for your interest, without having to pay enough to reduce the principle. However, an interest only payment comes with a deadline by which you must repay the entirety of the loan.

Another kind of home loan has a thirty year payment. Each payment goes towards the principle and interest consistently, as per a traditional loan. The fourth kind of payment is similar, but the amount must be paid off within fifteen years instead, which means that rates are higher.

Using a flexible rate loan option as a method for paying off a mortgage gives more payment flexibility. This can help some people pay off a loan more easily. However, it's important not to get trapped by the very low payments that this loan can have at some times.

In the end, it still has to be paid off. Before you sign for an ARM, it's important that you know the rates and terms that apply to it to enable you to get the best possible deal. Is it a good idea? It's questionable, so best that you talk to a few lenders before taking any action.
About the Author
Ken Black is a writer and owner of a number of financial websites. At Mortgages 101 you can learn more about adjustable rate mortgages .
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