Getting a mortgage can be an intimidating process full of unfamiliar jargon, which can make it hard for a first-time homebuyer to decide just what they want. Today, we’ll be helping you untangle mortgage terminology starting with the adjustable-rate mortgage, commonly known as an ARM.
These are a type of mortgage in which your interest rate is periodically adjusted by your lender, though it begins with an initial fixed rate period. This means that if interest rates go up, your monthly payment could go up — but, similarly, if rates go down, your monthly payment could go down.
So why would anyone take a gamble with rates that can change? The biggest reason is because the initial rates and payment you’ll get on an ARM tend to be lower than what you’d get on a fixed-rate mortgage — so savvy homebuyers can save with careful use of an adjustable-rate mortgage.
But the key to savings is understanding exactly what you’re getting into with an ARM — and being sure to read all of the fine print. We’ll walk through some common ARM terminology so you can know just what your lender is talking about:
- Index: The index for a loan is the metaphorical measuring stick used by your lender to determine interest rate adjustments.
- Margin: This is the percentage your lender marks up the index rate. The index rate plus the margin determines the interest rate you’ll pay for your loan.
- Initial fixed rate period: During some period of time at the beginning of your loan — from a year to ten years — your interest rates will not go up. If you plan to stay in the house for less time than this initial period, an adjustable rate mortgage can be a very good deal.
- Adjustment period: This is the period of time between rate adjustments, typically this will be annually after the initial period is over. For products like an 5/5 ARM, the period between adjustments could be longer.
- 1/1, 3/1, 5/1, 5/5: You’ll see ARMs described with a series of numbers like this. The first number is the initial period of the loan while the second number is the adjustment period of the loan. Thus, a 1/1 ARM would have an initial period of one year and have annual rate adjustments afterwards, while a 5/1 ARM would have an initial period of five years and annual adjustments after. A 5/5 ARM would have an initial period of five years and adjustments only every 5 years thereafter.
- Interest rate caps: Your loan can have several different types of interest rate caps. All ARMs will have an overall cap, which indicates how much your interest rate can rise over the lifetime of the loan. Then, it will typically have either a periodic cap — that limits the amount your interest can increase over each adjustment period — or a payment cap — which limits the amount your payment can rise each adjustment period. Before agreeing to an ARM, you’ll want to be sure these maximums are numbers you can live with. These caps spell out the details of how your ARM could change over time.
- Carryover: If a periodic cap kept your interest rate down over one adjustment period, the interest increase is typically carried over to the next adjustment period.
- Negative amortization: These are two words you don’t want to see together. It means that your monthly payments aren’t large enough to pay for the interest on your loan, so even while paying on time every month, the total you owe will go up.
Now that you have a basic understanding of the ins and outs of adjustable-rate mortgages, you’re ready to talk to your lender about the ARMs on offer — and decide whether one is the right choice for your mortgage.