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What are some key terms for an adjustable rate mortgage?

Here are some key terms that will help in better understanding an adjustable rate mortgage:

Initial rate - in an Adjustable Rate Mortgage (ARM), the lender offers you a lower initial rate for part of the mortgage term (usually for 1, 3 or 5 years).  After the initial period, the ARM rate may change depending on the index rate.

Index - an index is a rate determined by an independent third party and is used to determine interest rates.  Not all lenders use the same index.  Third Federal uses the Prime Rate as published in The Wall Street Journal as the Index for the Smart Rate Adjustable Mortgage.

Margin - the number of percentage points the lender adds to the index rate to calculate the interest rate of an adjustable rate mortgage (ARM) at each adjustment.

Fully Indexed Rate - is calculated by adding the index to the margin.  It is used to determine the annual percentage rate for the loan.  At the time of the rate adjustment, the fully indexed rate is used to determine the new rate and payment based on the remaining term of the loan.

For example, if the lender uses an index that currently is 4% and adds a 0% margin, the fully indexed rate would be:

Index                                  4%

+ Margin                             0%

Fully Indexed Rate             4%

If the index on this loan rose to 5%, the fully indexed rate would be 5% (5% + 0%).  If the index fell to 2%, the fully indexed rate would be 2% (2% + 0%).

Caps - typically with adjustable rate mortgages, there are two different caps - periodic and lifetime. 

  • A periodic cap limits how much the interest rate can increase or decrease from one adjustment to the next.   
  • A lifetime cap limits how much the interest rate can increase over the life of the loan.

Floor - is the minimum rate for which the interest rate can adjust down. 



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