The Adjustable Rate Mortgage or ARM, also known as variable rate mortgage, was introduced in the late 70s. Under this method, the interest rate of the loan can be adjusted up or down during the term of the loan to reflect the rise and fall in interest rates paid to savers by the lender. The Federal Home Loan Bank Board (FHLBB) limited adjustments to no more than ˝% to 1% every 6 months and a maximum of 2˝% over the life of the loan. In 1980, the FHLBB approved the use of a renegotiable rate mortgage loan. This was a 3-year loan with a requirement that every 1, 3 or 5 years the interest rate be adjusted to present market conditions.
At this time, the type of ARM a borrower is most likely to encounter requires that the interest rate charged be tied to some publicly available index that is mutually acceptable to the lender and borrower. The interest rate the lender is entitled to receive from the borrower rises and falls according to this index.
The benefit to the borrower of an ARM loan is that initially the interest rate charged for this type of loan is lower than the prevailing market rates. The disadvantage to the borrower is that if the index rises, the interest rate to the borrower and thus the monthly mortgage payment also rises. The amount of time between interest adjustments is called the adjustment period. The most common adjustment period is one year. Less commonly used periods are 6 months, 3 years and 5 years. When market rates are rising, the longer adjustment periods benefit the borrower.
Lenders are required by law to disclose an interest rate cap or ceiling on how much the interest rate an increase for any one adjustment period during the life of the loan. The two most commonly applied caps are 1% and 2% per year. In addition, an ARM should carry a payment cap or limit on how much the borrower’s monthly payment can increase in one year.
Before a borrower commits to any type of adjustable rate mortgage loan, he/she should ask the lender or mortgage broker to run several scenarios, including the payment schedule for a fixed rate and adjustable rate loan plus increasing interest rate scenarios on any adjustable rate. The consumer should always have as much information available before signing the loan papers to avoid future financial difficulties or even the possibility of bankruptcy or foreclosure.