Buying and selling houses is a complicated business. If it weren't, it would not require the services of tax preparers, attorneys, appraisers, land surveyors and professional salesman. People who wanted to buy and sell property would just sell it like they would a used car. Unfortunately, buying and selling property is somewhat complicated, particularly when it comes to loans. Studies have shown that most homeowners understand fixed rate loans fairly well, but that many people are confused by adjustable rate loans.
A fixed-rate loans has a rate of interest that is applied to the loan principal. That interest rate never changes, even if the loan is issued for 30 years or more. Adjustable rate mortgages, on the other hand, have rates that can change as soon as one year after the loan is issued. How the rate changes, when the rate changes, and by how much the rate can change will vary dramatically from lender to lender and from loan to loan. These adjustable loans, known in the industry as an "ARM", have their own terminology, which can sometimes confuse buyers.
Index - A financial market indicator that is used by the lender to determine if a rate change should take place. Once selected, the same indicator will be used for the life of the loan.
Margin - The percentage added to the indicator's value to determine the interest for your loan. A loan tied to a Treasury Bill with a 2.0% margin would have 2% added to the bill's interest rate. Thus, a Treasury Bill at 7% with a 2% margin would yield a 9% interest rate for the buyer.
Annual cap - Some loans have rates that change once a year. An annual cap specifies by how much the interest rate may adjust, either up or down. No matter what the index does, the annual rate cannoth adjust by more than the amount of this cap.
Lifetime cap - The maximum or minimum interest rate over the life of the loan. As with annual caps, these rates may not be exceeded, no matter what the value of the index to which the loan is tied should do.
These are the most commonly used terms for adjustable rate loans. The terms can vary widely from lender to lender; there are loans that adjust as soon as one year after being issued and others that will not adjust for a decade. These mortgages come in all shapes and sizes so as to accommodate the widest variety of customer. If you are considering taking out an adjustable rate loan, make sure you shop around in order to find the terms that best suit you.
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