Common Mortgage Types - Adjustable Rate Mortgage
An adjustable rate mortgage (ARM) involves two phases: a fixed rate term and a term of rate adjustments. The period between rate changes is called the adjustment period. The appeal of this type of loan is a low initial rate. After the initial rate period ends, the interest rate usually goes up.
The amount of the first rate adjustment is typically determined by adding a margin (already stipulated in the ARM contract) to the most recent value of a specified interest rate index. Most ARMs have "caps" on the amount by which the interest rate is allowed to increase. There are two types of interest rate caps: Periodic caps limit the interest rate increase from one adjustment period to the next, and overall caps limit the interest rate increase over the entire life of the loan.
There is also such a thing as a payment cap, which limit the entire monthly payment increase at the time of adjustment. By limiting the entire payment amount, but not necessarily limiting the interest rate increases, payment caps may put borrowers at risk of negative amortization. Negative amortization occurs when the balance of a mortgage increases because the monthly payment amount is not great enough to pay off all of the interest.