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Before you can understand how one adjustable rate mortgage (ARM) differs from another, you need to understand some of the terms thrown around by bankers and brokers. We at Unified Financial Group want you to feel equipped to understand discussions you may have with us, your agent, or any other broker or lender.
An index reflects the trend, up or down, of a given financial market over time and is used by a lender to set the interest rate on an ARM. Commonly used indexes include the Eleventh District Cost of Funds, the 1-, 2- or 3-year Treasury Index and the Libor (short for London InterBank Offer Rate). Some indexes are more volatile than others, which can in turn affect the frequency and degree of change in interest rate on the ARMs to which they are tied.
A margin is a percentage point or points that get added to an index to determine the interest rate of an ARM. The margin for a given loan is specified in the contract and typically falls within the range of 1.5% to 5%, though it can be higher.
This term is short for rate adjustment period and refers to the amount of time between rate adjustments, following the initial rate period. All ARMs have an initial period during which the rate remains fixed until the first adjustment. This period of time, also known as the initial rate period, can last anywhere from one month up to ten years or more.
Both the initial rate period and the rate adjustment period are often used to distinguish one ARM from another. For example, a 7/1 ARM is one with an initial rate period of seven years and subsequent rate adjustments every year thereafter.
This term may be short for rate adjustment cap. A rate adjustment cap imposes a limit on how much the interest rate on an ARM can increase at any given time. In most cases, rate adjustment caps are 1% or 2%, depending on the length of the initial rate period and the frequency of rate adjustments. On ARMs with a longer initial rate period during which the rate remains fixed, there may be two rate adjustment caps. The first will typically be much higher than the cap on subsequent adjustments.
Another type of cap is the payment adjustment cap, which limits the amount a payment can increase in a given period. A payment adjustment cap is usually expressed as a percentage of the current payment. For example, on an ARM with a 10% payment adjustment cap, the maximum payment adjustment on a monthly payment of $1,000 would be $100.
The interest rate cap is the maximum allowable rate as specified on the ARM loan contract. This cap will typically be around 5% to 6% higher than the initial rate for the ARM.
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