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Variable-Rate Loans (ARMs)

How The Adjustment Works

A variable-rate loan (or adjustable-rate mortgage, ARM) is one in which the interest rate can be adjusted periodically by the bank. The frequency with which it adjusts is called the adjustment period.

Your loan comes with an index and margin. The index is a published interest rate index typically set by market conditions. A well-known example is the prime rate, though it is rare for that to be used for mortgage loans. The most common is the One-Year T-Bill, the interest rate earned on treasury notes issued by the U.S. Government with a maturity date of one year. These securities sell on the open market and the rate can change from moment to moment, though generally it moves in very small increments in the short run. Other indexes commonly used are the Cost-of-Funds Index (COFI), which tends to be the most stable, and the London Interbank Offered Rate (LIBOR), which tends to be the most volatile. The margin is the amount over the index used to set your rate. A typical margin is between 2.5 and 3.0, meaning that your rate is set at the index (using 5.5% as an example) plus your margin (using 2.75% as an example) or 8.25%. Just prior to your adjustment date, the lender will look at the index called for in your contract, add your margin, and send you a letter telling you what your new rate will be.

NOTE
These loans often start with a "teaser rate," meaning that the start rate is below the fully indexed rate - that indicated by adding your index and margin together. The teaser rate allows you to make lower payments until your first adjustment date. However, if you start with a teaser rate, your loan will almost invariably go up when it adjusts. This is fine, if you anticipate it and can plan for it.

1-Year ARMs

The most common adjustable-rate loan is adjusted annually, though those which adjust every six months are popular, too. These loans typically have an adjustment cap of 2% per year or 1% each six months, meaning the interest rate cannot go up or down more than 2% (or 1%), and a lifetime cap of 6% over the start rate, meaning the rate can never exceed 6% more than the initial rate when you took out the loan. If rates stay where they are when you take this loan out, this loan will always be less expensive than a fixed-rate loan taken at the same time.


· Advantages: The initial cost and interest rate will be much lower for this loan than it will be for a fixed-rate loan, and the rate may stay lower than your fixed rate would have been indefinitely.

· Disadvantage: The rate can vary in an unpredictable manner, making planning difficult at best.
When it is a good idea:
· If you do not intend to keep this loan for very long.
· If you think your income will improve in the next year or two and want a low start rate for now.
· If you believe interest rates will stay low for as long as you intend to keep this loan.

Intermediate ARMs
These loans are adjustable, but the first adjustment date is extended, to three, five, seven or even ten years. The longer the "fixed" period, of course, the higher the initial rate. These loans typically will adjust annually after the first adjustment, have a 2% adjustment cap and a 6% lifetime cap, but not always so be sure to ask. In all other respects, they are similar to one-year ARMS.
· Advantages: Lower rate than fixed-rate loans, but longer fixed period than a one-year ARM to give you some time before they adjust.

· Disadvantages: At times the cost advantage over fixed-rate loans, particularly when the fixed period is seven or ten years, is so small it is not worth it. The adjustable rate, once it starts, is usually higher than a one-year ARM and almost always more than a monthly ARM.
When it is a good idea:
· If you have very little down payment and do not wish to get a fixed-rate mortgage. This gives you time before your loan adjusts.
· If you want to gamble a little, but not heavily, on interest rates not going up.

Monthly Adjustable
These are the loans that can have outrageously low start rates. The interest rate on these loans adjusts every month, although your payment may not. Often, you will be given a payment option with your loan statement: You may pay either the new payment amount to fully amortize your loan over 30 years, or you may continue to pay the old payment, even though it may not exactly amortize the loan. Some of these loans allow negative amortization. This means that you may even be allowed to pay less than the interest charges each month, but the unpaid interest is then added to the loan balance, and the amount you owe goes up! A negative-amortization loan can be great; it gives you the option of retaining a smaller payment without going into default on the loan. It may, however, be difficult to borrow more money in the form of a second mortgage. If you think this loan is for you, please discuss it carefully with your loan counselor.
· Advantages: These loans typically have lower start rates and lower margins than other adjustables.

· Disadvantages: You will never have certainty from one month to the next what your payment will be, though they typically do not vary a great deal in one month.
When it is a good idea:
· If you are very secure in your job, think rates will stay low, and plan on making at least the fully amortized payment each month, this loan may be the best deal for you.

 
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