An ARM loan must specify a specific time at which the interest rate may change. The adjustment period may be one year, three years, five years, or some other period. A three-year or five-year ARM loan usually offers the lower interest rate for the first period of adjustment and then converts to a one-year adjustable. The loan is still considered to be a 15- or 30-year loan.
An index is a measure of economic conditions. Indexes include U.S. Treasury securities, the Cost of Funds Index (COFI), the Federal Home Loan Bank average and LIBOR (The London bank-rate). A lender selects an index and bases the interest rate on that index plus the margin of profit desired to achieve certain yield, or profit. The index goes up or down regularly.
A lender sets a margin, usually between 2 percent and 3 percent, at the time of a loan’s origination, adds it to the current index to set the interest rate, assuring the desired yield on the loan.
Fully Indexed Rate, or Note Rate
The index plus the margin establishes the fully indexed rate, or note rate. This is often very close to the current market rate and is therefore not attractive to a borrower. To find a market for the adjustable rate loan product the lender often offers a lower initial or “teaser” rate.
The initial rate is lower than the current market rate and is fixed for the specific adjustment period set by the lender at the origination of the loan. In all probability, the interest rate will increase in the second adjustment period since the initial rate was deliberately set lower than market in order to attract borrowers to the product. This sudden increase in payment may create a serious problem for the borrower.
Interest Rate Caps
To protect borrowers from unlimited increases in the interest rate, lenders establish “caps”. The first cap sets the amount of increase (or decrease) allowed in each adjustment period. The second cap sets a maximum interest-rate increase over the life of the loan. Caps of 2/6 are common.
It is very important to understand the difference between an interest rate cap and a “payment” cap. Some mortgage products have a payment cap that assures the borrower that the payment will remain the same although the actual interest rate may fluctuate throughout the year. The difference between the interest paid and the interest due on the loan accumulates and is added to the principal balance due. This is called negative amortization and can result in customers owing more than they originally borrowed. A payment cap loan is risky for borrowers and is generally not a good option.
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