Adjustable-Rate Mortgages (ARMs)
For more definitions, see our Mortgage Glossary
Adjustable-rate mortgage (ARM)
A mortgage for which the interest rate is not fixed, but changes
during the life of the loan in line with movements in an index rate.
change, ARM monthly payments increase or decrease at intervals
determined by the lender; however, the change in the monthly payment amount is usually subject to a Cap. You may also see ARMs referred to as AMLs (adjustable-mortgage loans)
or VRMs (variable-rate mortgages).
Annual percentage rate (APR)
A measure of the cost of credit, expressed as a yearly interest rate. It
includes interest as well as points, mortgage insurance, and
other fees associated with the loan. Because all lenders
follow the same rules when calculating the APR, it provides consumers
with a good basis for comparing the cost of loans, including mortgages.
With a buydown, the seller pays an amount to the lender so that
the lender can give you a lower rate and lower payments, usually
for an early period in an ARM. The seller may increase the sales
price to cover the cost of the buydown. Buydowns can occur in all
types of mortgages, not just ARMs.
A limit on how much the interest rate or the monthly payment may
change, either at each adjustment or during the life of the mortgage.
Payment caps do not limit the amount of interest the lender is earning,
so they may cause negative amortization.
A provision in some ARMs that allows you to change the ARM to a
fixed-rate loan at some point during the term. Conversion is
usually allowed at the end of the first adjustment period.
At the time of the conversion, the new fixed rate is generally set
at one of the rates then prevailing for fixed-rate mortgages. The
conversion feature may be available at extra cost.
In an ARM with an initial rate discount, the lender gives up a
number of percentage points in interest to give you a lower rate
and lower payments for part of the mortgage term (usually for one
year or less). After the discount period, the ARM rate will probably
go up depending on the index rate.
The index is the measure of interest-rate changes that the lender
uses to decide how much the interest rate on an ARM will change
over time. No one can be sure when an index rate will go up or down.
To help you get an idea of how to compare different indexes, the
following chart shows a few common indexes over an eleven-year period
(1994-2004). As you can see, some index rates tend to be higher
than others, and some more volatile (if a lender bases interest-rate
adjustments on the average value of an index over time, however,
your interest rate would not be as volatile). You should ask your
lender how the index for any ARM you are considering has changed
in recent years, and where the index is reported.
||This graph shows interest rates from 1994
to 2004, including the national average mortgage contract interest
rate (from 7.3% in 1994 to 5.6% in 2004), the interest rate
on one year Treasury securities (from 5.3% in 1994 to 2.7% in
2004), and the cost of funds for savings and loan associations
(from 4.3% in 1994 to 2.1% in 2004).
The number of percentage points the lender adds to the index rate
to calculate the ARM interest rate at each adjustment.
amortization occurs when the monthly payments do not cover all the
interest cost. The interest cost that is not covered is added to
the unpaid principal balance. This means that even after making
many payments, you could owe more than you did at the beginning
of the loan. Negative amortization can occur when an ARM has a payment
cap that results in monthly payments not high enough to cover the
charges imposed by the lender that are usually prepaid by the consumer
at settlement but can sometimes be financed by adding them to the
mortgage amount. One point is equal to 1 percent of the principal amount of your
mortgage. For example, if the mortgage is for $65,000, one point
equals $650. Lenders frequently charge points in both fixed-rate
and adjustable-rate mortgages in order to increase the yield on
the mortgage and to cover loan closing costs. These points usually
are collected at closing and may be paid by the borrower or the
home seller, or may be split between them.
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is subject to change, and may not apply to all individual circumstances.
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