An adjustable rate mortgage is one where the interest rate can change periodically. Many people do not think they have an ARM because of the initial fixed rate portion of the mortgage. But if the rate can ever change..even once..it’s an adjustable rate mortgage.

Adjustable Rate Mortgage Definition

The 5 1 adjustable rate mortgage was one of the most popular ones so we will use that an an example. The (5) means for the first 5 years, your rate will not change. The (1) means every 1 year after the first 5 are up, your mortgage rate will adjust up or down.

Some were even sold also as an interest only mortgage. So not only will the rate adjust but the borrower was only paying the interest with no principal paydown. Others are an option adjustable rate mortgage. These are even more dangerous in that they adjust every month, they have an interest only choice for a payment, or they even have the choice of a minimum payment which means it does not even cover all the interest for that month.

Adjustable rate mortgages have a long history in the US starting back in the 1960′s and then once inflation took off in the 1970′s, folks noticed the ARMs were jumping in rate 3% in as little as a month or two. This rate climbing had no end in sight. Many experienced their loans run up all the way to the 18% high in 1979.

Learning from this experience, today’s ARMs have both periodic adjustment caps and lifetime caps to protect consumers. Most conventional ARMs have no more than a 2% periodic cap and a 5 or 6% lifetime cap. For more on interest rate recalculation see Adjustment Period.

At adjustment, the new rate is calculated by adding the ARMs margin to the index. Many indexes used for US ARMs are the COFI, the MTA, the 1 year Treasury, and the LIBOR. Many home equity loans use the Prime Rate as an index.

A good chunk of the foreclosures from the mortgage meltdown were adjustable rate mortgages or they are also known as variable rate mortgages. They were sold with no risk. Borrowers were told they could refinance before the rate started to adjust but as many found out, their property values dropped and they could not.

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