adjustable-rate mortgage

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Adjustable-rate mortgage (ARM)

A mortgage that features predetermined adjustments of the loan interest rate at regular intervals based on an established index. The interest rate is adjusted at each interval to a rate equivalent to the index value plus a predetermined spread, or margin, over the index, usually subject to per-interval and to life-of-loan interest rate and/or payment rate caps.

Adjustable Rate Mortgage

A mortgage with an interest rate that changes periodically. Generally speaking, an adjustable rate mortgage is linked to some major benchmark rate; for example, the interest rate may be stated as "LIBOR + 1%." The mortgage may or may not have a cap on how much the interest rate can rise or fall, or on how often the interest rate may change. Very often, the initial interest rate for an adjustable-rate mortgage is lower than that for a fixed-rate mortgage. This allows more people to qualify for an adjustable-rate mortgage; however, this kind of mortgage can be risky because the interest rate (and therefore the monthly payment) can rise unexpectedly. Indeed the prevalence of ARMs has been blamed for the housing bubble in the mid-2000s and the subsequent recession. See also: Credit Crunch, Teaser Rate.

adjustable-rate mortgage (ARM)

An instrument granting a security interest in real property as collateral for a promissory note with interest rates that change from time to time, as specified in the note.The note should contain

• An initial rate, or the first interest rate to be charged.

• Areference number, called the index, to be used in calculating future interest rates. As the index increases or decreases, the loan interest rate will increase or decrease by the same amount.

• The index could be the Federal Reserve overnight funds rate plus a certain percentage, it could be the prime rate charged by CitiBank to its most credit-worthy customers (CitiBank Prime), or any number of other indices. You want to avoid any adjustable-rate note with references to vague generalities such as “market rate” or rates charged by small unknown lenders.

• Astatement regarding the frequency at which the rate may change. Commercial loans typically change every time the index changes. Consumer loans usually change only once or twice a year.

• Astatement regarding the maximum amount the interest may increase each time, called a periodic cap. (Consumer loans usually have periodic caps, but not commercial loans.)

• Astatement regarding the maximum amount the interest may increase over the lifetime of the loan, called a lifetime cap. (Consumer loans usually have a lifetime cap around 5 percent; commercial loans usually do not have any lifetime caps.)

Many adjustable-rate mortgages for home loans have a conversion clause allowing (or even requiring) change to a fixed rate of interest after a specified period of time,usually 5 or 7 years.This gives the homeowner the ability to lock in a fixed rate without having to go through the trouble and expense of a refinance.

One type of adjustable-rate mortgage is the fixed-payment, adjustable-rate loan. With it, the consumer pays the same amount each month, even if interest rates rise to the point that the payment does not pay the currently accruing interest.The unpaid interest is added to the principal of the loan. In such a situation,the loan is said to be negatively amortizing,meaning the principal balance grows larger each month rather than smaller.