Fixed Rate Mortgage is a loan where the interest rate remains fixed for the term of the mortgage. Typically, fixed rate mortgages are for 30, 15 or 10 years.

An Adjustable Rate Mortgage (ARM) is a loan where the interest rate can 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.

An ARM: The Advantages and Disadvantages

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 over a long period than a fixed-rate loan if interest rates remain steady or decline. One disadvantage to an ARM is that an increase in interest rates will lead to higher monthly payments in the future.

ARM Interest Rate: Index plus Margin

The calculated interest rates for ARMs are based on an index rate plus a margin. The index is published rate such as the prime, T-Bill, LIBOR or the 11th District Cost of Funds. Changes in the index rate can cause changes in your ARM rate. If the index rates move 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 your particular 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 interest rate. Generally, the margin will remain constant over the life of your loan.

Arm Adjustment Periods

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, every three years, or every five 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.

Interest Rate Caps

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.

-Overall caps (also called "ceilings or "lifetime caps") which limit the interest rate increase over the life of the loan.

Negative Amortization

Some types of ARMs offer payment caps (as differentiated from interest rate caps) which limit the amount the monthly payment can increase. However, payment caps do not limit the amount the interest can increase. This can cause negative amortization - when your monthly mortgage payments are not large enough to pay all the interest due on your mortgage balance and actually increases it. Interest may also be charged on the additional amount added to your debt. With a Negative Amortization ARM, you may owe more later in the loan term than you did at the start.

Your loan documents will reflect whether you have a negative amortization loan, and your monthly statement will give you the option to pay the minimum payment, interest-only payment, or the fully amortized amount due.

ARM Prepayment or Conversion

Prepayment is the payment of all or part of the mortgage debt before it is due. Some loan agreements may require you to pay special fees or penalties if you pay off the ARM early.

Please review the Adjustable Rate Rider that was enclosed with your closing documents for a detailed information regarding prepayment of your ARM.