+ I'm considering an adjustable-rate mortgage (ARM) - What should I watch out for?
Adjustable rate mortgages can be very complicated. There are many parts to an adjustable rate mortgage that can affect how much the mortgage will cost you. If you are considering an ARM, make sure to read the terms carefully and ask lots of questions until you understand exactly how each of these features of the mortgage works.
Here are key questions to ask your lender about your loan:
- When and how often will the interest rate be adjusted?
Most adjustable-rate mortgages have fixed interest rates for an initial period – for example, 3 or 5 years – and are typically re-calculated once per year after that. But this structure is not required. Some loans don’t have an initial fixed-rate period, and they can adjust more or less frequently. Make sure you understand exactly how often the rate on your loan will re-adjust.
- What is the index and margin on the loan?
The index and margin control what your interest rate will be at each adjustment for an adjustable-rate mortgage. Learn more about indexes and margins and how they work.
- What are the rate caps on the loan?The rate caps control the maximum amount your interest rate can change at each adjustment, and in total, over the life of the loan. Learn more about rate caps and how they work.
- Will the payment be recalculated at the same time as the interest rate? For most loans, the payment is recalculated each time the interest rate adjusts. However, some loans may recalculate the payment amount less frequently. If your interest rate has increased but your payment has not, your loan balance could increase.
- Can your loan balance increase? Sometimes the balance of a loan can actually increase rather than decrease even though you are making payments on the mortgage. For example, your loan balance might increase if your monthly payment is not enough to cover the interest on your loan. Check to see whether the balance on your loan is allowed to increase after closing. These types of loans are called negative amortization loans. Learn more about negative amortization loans.
- Does the loan have a floor rate? If the interest rate adjusts up, can it adjust back down in a future period? Some loans have a “floor rate,” or a minimum rate. Even if the index goes lower, the rate on these loans does not adjust below the floor rate. Loans can also have a clause that says that the interest rate can only ever adjust up, not down. Both of these features can make the loan more expensive and risky for you, by increasing the chance that your payments will go up in the future. If you are considering a loan with either of these features, ask the lender what benefit you would get for accepting these terms. Ask for a quote for a similar loan without these features, so you can make an informed decision.
- Does the loan have a prepayment penalty? Check to see if there is a fee for paying your loan back early. Most loans do not have prepayment penalties, but it’s a good idea to double-check. Learn more about prepayment penalties.