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Adjustable Rate Mortgage (ARM)
What is an Adjustable Rate Mortgage (ARM)?
An Adjustable Rate Mortgage (ARM) is a loan where the interest rate may change periodically. The interest rate is based on an "index" that may go up or down during the lifetime of the loan. As a result, your monthly payments may also go up or down during the lifetime of the loan. The ARM Note stipulates the frequency and the index for the interest rate and principal and interest adjustments. 

There are a number of advantages to an ARM.

Generally, an ARM offers a lower initial interest rate than a fixed-rate loan. With an ARM, you may be able to qualify for a larger amount because the decision is sometimes based on current income and the first year's monthly payments, which will most likely be lower. An ARM can be less expensive than a fixed-rate loan if interest rates remain steady or decline over a long period of time.

One disadvantage to an ARM is that an increase in interest rates will lead to higher monthly payments of principal and interest in the future. Another disadvantage is that the principal and interest payments are not fixed.

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How is the interest rate calculated on an ARM loan?
The calculated interest rates for ARMs are based on an index rate plus a margin. The index is a published rate such as the Prime Rate, Treasury Bill index, LIBOR or the 11th District Cost of Funds (COFI). Changes in the index rate can cause changes in your ARM rate. If the index rate moves up, so can your mortgage rate. On the other hand, if the index rate drops, so can your mortgage rate and your monthly payment. The index for an ARM loan is established at the time of application.

In determining the interest rate on your ARM, lenders add a few percentage points to the index rate. This is called the margin, and it is added to the index to determine your new interest rate at each adjustment. The margin will remain constant over the life of your loan.

All of these factors are outlined and agreed to when you sign your ARM note.

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How can the lower initial interest rate affect future ARM changes?
The initial interest rate is usually discounted depending on the number of points paid at closing. Even if the index rate remains the same on the first ARM change, the interest rate could increase. This is caused by the introductory rate being discounted when the ARM loan is originated.
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What is the ARM adjustment period?
The period between one rate change and the next is called the adjustment period. With most ARMs, the interest rate and the monthly payment can change or adjust every six months, once a year, after three years, every three years, five years, seven or ten years. For example, a loan with an adjustment period of one year is called a "one-year ARM" and the interest rate and payment can change once every year. The frequency of ARM adjustments is established at the time of application and the terms are outlined on the ARM note. Our Informational Rates page provides you with today's rates for several of the leading indices for ARM adjustments and conversion.
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What is an interest rate cap?
An interest rate cap limits the amount your interest rate can change. There are two types of interest caps: periodic caps, which limit the interest rate increase from one adjustment period to the next and overall caps (also called "ceilings" or "lifetime caps"). The absolute value of the lifetime caps may not be determined until you lock in your loan.
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What is an ARM conversion?
Conversion is the provision in some ARMs that allows you to change the ARM to a fixed-rate loan at some point during the term of your loan. If you do convert your ARM, the new interest rate may be higher than current market fixed rates. Please review the Adjustable Rate Rider that was enclosed with your closing documents for specific provisions and conversion periods on your ARM. The conversion option is not a standard feature of an ARM loan and is actually priced higher at closing than a non-convertible ARM. Our Informational Rates page provides you with today's rates for several of the leading indices for ARM adjustments and conversion.
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