Adjustable Rate Mortgage Components
To understand an Adjustable Rate Mortgage (ARM), you must have a working knowledge of its components. Those components are:
The index is the financial indicator that rises and falls, based primarily on economic fluctuations. It is usually an indicator and is therefore the basis of all future interest adjustments on the loan. Mortgage lenders currently use a variety of indexes.
This is the lender’s loan costs plus profit. Then, you add the margin to the index to determine the interest rate. The cost of funds is the index. Furthermore, the margin is the lender’s cost of doing business, plus profit.
This is the rate during the initial period of the loan, which is sometimes lower than the note rate. This initial interest may be a teaser rate, an unusually low rate to entice buyers and allow them to more readily qualify for the loan.
The actual interest rate charged for a particular loan program equals the note rate.
The intervals at which the interest is scheduled to change during the life of the loan (e.g. annually).
Interest Rate Caps:
The limit placed on the up-and-down movement of the interest rate equals the Interest Rate Caps. The specified per period adjustment and lifetime adjustment (e.g. a cap of 2 and 6 means 2% interest increase maximum per adjustment with a 6% interest increase maximum over the life of the loan).
Negative Amortization occurs when a payment is insufficient to cover the interest on a loan. We add back the shortfall amount to the principal balance.
This is the option to change from an ARM to a fixed-rate loan. Sometimes a lender will charge a conversion fee.
The interest rate increases in excess of the amount allowed by the caps that can be applied at later interest rate adjustments (a component that most newer ARMs are deleting).