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The Consumer Handbook developed by the Federal Reserve Board defines Adjustable-rate mortgages (ARMs) as loans with interest rates that change. According to the Board, an ARM difers from a fixed-rate mortgage in many ways. It points out that with a fixed-rate mortgage, the interest rate stays the same during the life of the loan while with an ARM, the interest rate changes periodically, usually in relation to an index, and payments may go up or down accordingly. 
An adjustable-rate mortgage (ARM) Glossary accompanies the discussion useful to anyone looking for the right loan or to refinance:
  • Adjustable-rate mortgage (ARM) - A mortgage the does not have a fixed interest rate. The rate changes during the life of the loan based on movements in an index rate, such as the rate for Treasury securities or the Cost of Funds Index.
  • Annual percentage rate (APR) - A measure of the cost of credit, expressed as a yearly rate. It includes interest as well as points, broker fees, and certain other credit charges that you are required to pay. Because all lenders follow the same rules when calculating the APR, it provides you with a good basis for comparing the cost of loans, including mortgages, over the term of the loan.
  • Balloon Payment - A lump-sum payment that may be required when a mortgage loan ends. This can happen when the lender allows you to make smaller payments until the very end of the loan. A balloon payment will be a much larger payment compared with the other monthly payments you made.
  • Buydown - With a buydown, the seller pays an amount to the lender so that the lender can give you a lower rate and lower payments, usually for an initial period in an ARM. The seller may increase the sales price to cover the cost of the buydown. Buydowns can occur in all types of mortgages, not just ARMs.
  • Cap, Interest rate - A limit on the amount your interest rate can increase. Interest caps come in two versions: periodic adjustment caps, which limit the interest-rate increase from one adjustment period to another ; and lifetime caps, which limit the interest rate increase over the life of the loan. By law, virtually all ARMs must have an overall cap.
  • Conversion clause - A provision in some ARMs that allows you to change the ARM to a fixed-rate loan at some point during the term. Conversion is usually allowed at the end of the first adjustment period. At the time of the conversion, the new fixed rate is generally set at one of the rates then prevailing for fixed-rate mortgages. The conversion feature may be available at no extra cost.
  • Discounted initial rate (also known as a start rate or teaser rate) - In an ARM with a discounted initial rate, the lender offers you a lower rate and lower payments for the part of the mortgage term (usually for 1,3, or 5 years). After the discount period, the ARM rate will probably go up depending on the index rate. Discounts can occur in all types of mortgages, not just ARMs.
  • Equity - THe difference between fair market value of the home and the outstanding balance on your mortgage plus any outstanding home equity loans.
  • Hybrid ARM - These ARMS are a mix--or a hybrid--of a fixed-rate period and an adjustable-rate period. The interest rate is fixed for the first several years of the loan; after that, the rate could adjust annually. For example, hybrid ARMs can be advertised as 3/1 or 5/1--the first number tells you how long the fixed-interest rate period will be and the second number tells you how often the rate will adjust after the initial period.
  • Index - The economic indicator used to calculate interest-rate adjustment for adjustable-rate mortgages. No one can be sure when an index rate will go up or down.
  • Interest - The price paid for borrowing money, usually given in percentages and an annual rate.
  • Interest-only payment ARM - An I-O payment ARM plan allows you to pay only the interest for a specified number of years. After that, you must repay both the principal and interest over the remaining term of the loan.
  • Margin - THe number of percentage points the lender adds to the index rate to calculate the ARM interest rate at each adjustment.
  • Negative amortization - Occurs when the monthly payments do not cover all the interest owed. The interest that is not paid in the monthly payment is added to the loan balance. This means that even after making many payments, you could owe more than you did at the beginning of the loan. Negative amortization can occur when an ARM has a payment cap that results in monthly payments that are not high enough to cover the interest rate or when the minimum payments are set at an amount lower than the amount you owe in interest.
  • Payment-option ARM - An ARM that allows you to choose among several paymnet options each month. The options typically include (1) a traditional amortizating payment of principal and interest, (2) an interest only payment, or (3) a minimum (or limited) payment that may be less than the amount of interest due that month. If you choose the minimum-payment option, the amount of any interest you do not pay will be added to the principal of your loan.
  • Points (may be called discount points) - One point is equal to 1 percent of the principal amount of your mortgage. For example, if the mortgage is for $200,000, one point equals $2000. Lenders frequently charge points in both fixed-rate and adjustable-rate mortgages in order to cover loan origination costs or to provide additional compensation to the lender or broker. These points usually are collected at closing and may be paid by the borrower or the home seller, or may be split between them. Discount points (sometimes called discount fees) are points that you voluntarily choose to pay in return for a lower interest rate.
  • Prepayment penalty - Extra fees that may be due if you pay off the loan early by refinancing your loan or selling your home, usually limited to the first 3 to 5 years of the loan's term. If your loan includes a prepayment penalty, be aware of the penalty you would have to pay. Compare the length of the prepayment penalty period with the first adjustment period of the ARM to see if refinancing is cost-effective before the loan first adjusts. Some loans may have prepayment penalties even if you make only a partial prepayment.
  • Principal - The amount of money borrowed or the amount still owed on a loan.
 Article by Connie I. Ko
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  • Last edited September 24 2012
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