A mortgage with an interest rate that can adjust during the term of the loan
When it comes to adjustable rate mortgages, the interest rates can be dramatically lower than the conventional 30 Year or 15 Year fixed interest rates. The risk, however, is an inherent one. The interest rates can rise. Now there are certain type of loans like the 3/1 ARM, 5/1 ARM that offers a fixed rate, then goes into an adjustable. Many people like these types of programs because they know they will be selling the home before it goes into the adjustable phase of the loan.
Here are some terms to understand the ARM:
Start rate: Another name for this loan is called the introductory rate, or the teaser rate. This is the rate that is used to calculate the first payment(s) the borrower will make.
Introductory period: This is the length of time the introductory rate applies. Once the introductory period ends, it goes into adjustable rate that may go up or down based on index its connected with.
Index: ARMs are tied to movements in the financial market, for example the LIBOR (London Interbank Offered Rate). This index has a margin associated to it. Therefore your rate will then be margin + index.
Margin: This is a value agreed upon by the lender and the borrower. It is added to the loan’s index to come up with the fully indexed rate.
Lifetime cap: This is the ceiling the loan can go to if the LIBOR for example adjusts to the highest index. So even if the index is higher than the lifetime cap, your interest rates caps to the lifetime cap.
Rate Floor: This is the lowest rate the loan can have regardless of what happens in the market.