Components of Adjustable Rate Mortgages
To understand an ARM, you must have a working knowledge of its components.
Those components are:
Index: A 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.
Margin: A lender's loan cost plus profit. The margin is added
to the index to determine the interest rate because the index is the cost of
funds and the margin in the lender's cost of doing business plus profit.
Initial Interest: 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.
Note Rate: The actual interest rate charged for a particular
Adjustment Period: The interval at which the interest is scheduled
to change during the life of the loan (e.g. annually).
Interest Rate Caps: Limit placed on the up-and-down movement
of the interest rate, 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. The shortfall amount is added back onto the
Convertibility: The option to change from an ARM to a fixed-rate
loan. A conversion fee may be charged.
Carryover: 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).