An adjustable rate mortgage has an interest rate that is based upon a published index; and will adjust strictly according to that index regardless of the wishes of the lender, borrower, or any third party. Much like the stock market, exact prediction of the future position of an interest rate is impossible, however, the overall trend of any given index for which an adjustable rate mortgage is based upon can and should be observed prior to any decision or agreement. All adjustable rate mortgages are based upon a rate that can and should be investigated to avoid any future “surprises” regardless of whom the adjustable rate mortgage is offered by. Our Common ARM Indexes page lists many of the typical indexes that Adjustable Rate Mortgages are based upon.

Are ARM rates tied to the discount interest rate? (The discount interest rate is set by the Federal Reserve and is always discussed by news stations when it is adjusted. See our Interest Rates section for a more in-depth explanation) Yes, somewhat. All American interest indexes are indirectly tied to the discount interest rate; however, how they adjust in relationship to the discount rate is different. Some may change instantaneously others may lag behind due to the particular characteristics for which the index is based upon. The main theme to recognize is the trend of the discount interest rate; If the trend is heading up (or down) all interest rates will eventually follow – there may be a short period where it appears that rates are heading in different directions (once again, which is based upon the factors that influence the particular interest rate) but the trend direction of the discount interest rate is the direction where all interest indexes are eventually headed.

Adjustable Rate Mortgages are available in many initial payment period and adjustment interval flavors: 3/1, 5/1, 7/1, 10/1, 3/3, etc. The following sketch shows what these number ratios mean.

Many Adjustable Rate Mortgages offer a cap to control the maximum amount of interest that a loan can adjust in any given period as well as a lifetime cap that dictates the maximum amount of interest an Adjustable Rate Mortgage can accrue over the lifetime of the loan. Some ARM’s specify a maximum dollar amount that can be required for a monthly payment or a maximum dollar amount that can be added to a payment regardless of the amount dictated by an interest rate adjustment.

Advantages:

• Low initial monthly mortgage payments.

Disadvantages:

• Adjustable Rate Mortgages can adjust sharply upward after the initial payment period if interest rates move significantly upward.
• ARM’s can be confusing.

Adjustable Rate Mortgage Types & Options:

• Bi-weekly mortgage or bi-monthly mortgage – As the names imply, these mortgage types have two payments per month. What’s the difference you ask? Plenty, actually. A bi-monthly mortgage is essentially the same as a typical monthly mortgage except that payments are made twice a month - monthly mortgage payment split in half and paid every two weeks. A bi-weekly mortgage deducts the amount reduced from the principal with every mortgage payment so that the total calculated interest is reduced and therefore reduces the term of the loan. This may seem like peanuts at face value but actually can be quite substantial as a typical 30-year fixed rate mortgage that is set up for bi-weekly payments will be paid off in a little under 24 years. Please see our Bi-weekly Mortgage Rate section to view some Bi-weekly Mortgage Rates.
• Jumbo or non-conforming mortgage – A Jumbo or non-conforming mortgage is a loan in excess of $417,000. This figure is currently the eligibility limit for purchase by Fannie Mae or Freddie Mac. Nearly all Jumbo or non-conforming mortgages have a higher interest rate then their counterpart; the conforming mortgage. At the time of this writing, February 2008, there is current legislation under consideration to substantially raise this amount to somewhere around $600,000.
• Balloon mortgage – A balloon mortgage is a mortgage that will have payments that are calculated much the same way as a 15-year fixed rate mortgage, 20-year fixed rate mortgage, 30-year fixed rate mortgage, or 40-year fixed rate mortgage dependant on which option you choose. After a set period of time, typically 5-years, 7-years, or 10-years, the total amount loaned minus the mortgage payments made will be due in a lump sum. Rates for these types of loans are usually lower than both Fixed Rate Mortgage interest rates and Adjustable Rate Mortgage interest rates.
• Construction Mortgage – A Construction Mortgage is often found as a two-part loan. The first part of the Construction Mortgage will typically be an interest only loan that will charge the loan purchaser an interest only payment based on the amount of the loan that has been spent on the construction project – these loans are usually dispersed on a borrow as you need basis up to a fixed amount. The construction portion of the loan will generally have a term limit of between six and twelve months. The second part of the Construction Mortgage begins upon completion of the construction project at which time the loan purchaser can select the type of mortgage to "roll" the Construction loan into. This can be a Fixed Rate Mortgage, Adjustable Rate Mortgage, Jumbo Mortgage, Balloon Mortgage, etc. A Construction Mortgage will usually have two separate closing periods; one at the construction commencement, the other at construction completion both incurring separate closing fees. Recently some mortgage providers have begun to offer "single closing" construction loans.
• Interest-Only Mortgage – An Interest-Only Mortgage is a mortgage where a monthly mortgage payment will only cover the interest portion of the loan. This interest-only period of the loan will typically have a term of three, five, seven, or ten years after which the monthly mortgage payments will increase to begin including a portion of the principal of the loan. An Interest-Only mortgage is often selected due to its attractive initial low monthly payments. Interest-Only Mortgage options are available for both Fixed Rate Mortgages and Adjustable Rate Mortgages.
• Second Mortgage – A second Mortgage is often a Home Equity Loan or Home Equity Line of Credit (HELOC) both of which are discussed in their own sections. The Second Mortgage can be a Fixed Rate Mortgage, an Adjustable Rate Mortgage, or a Home Equity Line of Credit all with their differing interest rate characteristics. In the event of default on a home with both a primary and Second Mortgage, upon fund recovery the primary mortgage is paid first leaving the Second Mortgage with whatever (if anything) is left. As a result, a Second Mortgage will often have a higher interest rate than a primary mortgage (with the exception of the adjustable rate second which will often have lower interest rates much like an Adjustable Rate Mortgage). See our Second Mortgage Rate Calculator section to see some Second Mortgage Rates.

Before You Sign – What to watch out for:

• Ask your lender, Mortgage broker, or Title officer for a copy of your Balance Sheet, Closing Statement, or Settlement Cost Sheet. (This document is called many different things by different institutions; use any of these terms and your lender, broker, or title officer should understand what you’re looking for.) By law, a borrower is entitled to review the settlement cost sheet one business day before closing on the loan – You absolutely must exercise this right and ask questions if you find something you don’t understand! Please follow the link above to find out what should be included in this document and why it matters to you.
• Check introductory rates and periods. Ask your lender to map the loan out precisely in a fashion you understand.
• Check for and ask about prepayment penalties
• Verify account maintenance fees and/or servicing fees before signing.
• Ask your lender, broker, or Title officer for an accounting estimate of all up-front fees you will be charged. These charges may come from the lender, title company, other third party, etc.
• Interest Only Mortgage Options – Understand when principal will begin to be added to your monthly payments.
• Balloon Mortgage Options - Understand exactly when the balloon payment will be due.
• Construction Mortgage – to avoid an unexpected set of second closing costs, Verify whether your Construction Mortgage has one or two closings (see Construction Mortgage above).
• A couple minor additional costs not included on the preliminary closing statement due to last minute unforeseen charges and exact interest calculations should be expected. These costs should be very small and typically not amount to more than a couple hundred dollars.

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