Adjustable rate mortgage
An adjustable rate mortgage (ARM), variable rate mortgage or floating rate mortgage is a mortgage loan where the interest rate on the note is periodically adjusted based on an index. In economics and finance, an index is a single number calculated from an array of prices or of quantities. This is done to ensure a steady margin for the lender, whose own cost of funding will usually be related to the index. Consequently, payments made by the borrower may change over time with the changing interest rate (alternatively, the term of the loan may change). Adjustable ratemortgages are characterized by their index and limitations on charges (caps).
Any mortgage where payments made by the borrower may increase over time brings with it the risk of financial hardship to the borrower. To limit this risk, limitations on chargesknown as caps in the industryare a common feature of adjustable rate mortgages.
Caps typically apply to three characteristics of the mortgage, they are:
a) Frequency of the interest rate change.
b) Periodic change in interest rate.
c) Total change in interest rate over the life of the loan, sometimes called life cap.
Hybrid ARMs:
a hybridadjustable-rate mortgage (ARM) is one where the interest rate on the note is fixed for a period of time, then floats thereafter. The "hybrid" refers to the blend of fixed rate and adjustable rate characteristics found inhybrid ARMs.
Option ARMs: an "option ARM" is a loan where the borrower has the option of making either a specified minimum payment, an interest-only payment, or a 15-year or 30-year fixed rate payment in a given month.
In many countries, banks or similar financial institutions are the primary originators of mortgages. For banks that are funded from customer deposits, the customer deposits will typically have much shorter terms than residential mortgages. If a bank were to offer large volumes of mortgages at fixed rates but to derive most of its funding from deposits (or other short-term sources of funds), the bank would have an asset-liability mismatch: in this case, it would be running the risk that the interest income from its mortgage portfolio would be less than it needed to pay its depositors. To avoid this risk, many mortgage originators will sell or securitize their mortgages. In this perspective, banks and other financial institutions offer adjustable rate mortgages because it reduces risk and matches their sources of funding.
In many countries, it is not feasible for banks to borrow at fixed rates for very long terms; in these cases, the only feasible type of mortgage for banks to offer may be adjustable rate mortgages (barring some form of government intervention). For those who plan to move within a relatively short period of time (three to seven years), they are attractive because they often include a lower, fixed rate of interest for the first three, five, or seven years of the loan, after which the interest rate fluctuates accordingly.
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