Adjustable-rate mortgages (or ARMs) are great programs for the right borrowers. They can offer more flexibility than fixed-rate mortgages, and today's ARMs have reasonable adjustment caps built in to protect borrowers against rates increasing too much when they do adjust.
The most common hybrid ARM has an initial fixed-rate period and an adjustable rate when that time concludes. The two most popular terms of ARMs are 5/1 and 7/1. These 30-year loans allow you to have a fixed-rate for a certain number of years before the rate becomes adjustable. The first number in these loan terms indicates the number of years in which the interest rate will be fixed. For example, in a 5/1 ARM, the interest rate is a fixed rate for the first five years. The second number in these loans terms indicates how often the interest rate will be adjusted after the fixed period of time. For example, after the fixed portion of your term in a 5/1 ARM, the rate can change once per year.
There are four key figures to understand when looking into an adjustable-rate mortgage. The most commonly known is the initial rate, which is typically lower than a fixed interest rate program with the same term. The two important figures to consider along with the initial rate are the margin and the index. The margin is a figure that will not change, while the index can rise and fall. Combining the margin and the index will give you the fully indexed rate. This is the rate at which you will pay your mortgage once the initial fixed-rate period concludes. The fourth important figure to understand is the cap. Your payment caps will tell you when and how often your rate will adjust. The cap is written as three numbers, and represents the initial, periodic, and lifetime caps. For example, if you have 5/1/5 caps on a 7/1 ARM and your rate starts at 3%, your initial rate increase starting at month 85 is capped at 5% over the start rate (or 8% in this example). The periodic change every 12 months is then capped at 1% over the prior year's rate, with a lifetime cap of 5%. Therefore, 8% would be the highest that this rate could ever be.
Knowing which figures to discuss during the mortgage process can greatly improve your understanding of your adjustable-rate mortgage.
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