Most adjustable rate loans start out with a fixed rate for a specified length of time and change to a variable rate loan. These work well when people expect their income to increase dramatically after a few years, or those planning to move from the house after a few years. The most common loan lengths are 3/1, 5/1, 7/1, and 10/1. The first number is the length of time in years the loan is at a fixed rate. The second number is the length of time in years that it would adjust in after the fixed rate period. There is a cap on the amount of percentage points it can go up after the fixed rate period. It is usually 2% a year. With these types of loans you may pay more principal and less interest in the long run.
Adjustable Rate Mortgages (ARM’s)
- Also called variable-rate loans.
- Starts out with a lower interest rate, and changes according to market fluctuations. How often it changes depends on the terms of the loan. The most common adjustment term is once every year.
- ARM’s have limits, or caps, on the number of percentage points it can go up each year. It also has caps on how much it can go up for the life of the loan. This happens according to the terms of the loan you choose. For example- your mortgage starts at a rate of 4%. If you have a yearly cap of 2 points, and a life long cap of 6 points, this is what can happen to the percentage rate of your loan. At the end of one year your mortgage company can increase your rate by two points, to 6%. At the end of the second year, your mortgage company can increase your rate by 2 points, to 8%. (A total of 4 percentage points higher than the original term of the loan.) At the end of the third year, your mortgage company can increase your rate by 2 points, to 10%. A total of 6 percentage points higher than the original terms of the loan.) At this point you have had an increase of 6 percentage points and can no longer have your interest rate raised for the life of your loan. Of course these changes are tied to the index that your ARM is based on.
- A convertible ARM allows you to have the lower interest rates for the beginning of the loan, but the option to convert to a fixed rate loan when you choose. This usually requires a conversion fee as set up by your loan institution.