Conventional or fixed rate mortgage - The loan rate does not fluctuate with changes in interest rates. It tends to present higher rates than adjustable rate mortgages. 30 and 15 years more common.
Adjustable Rate Mortgage (ARM)
Allows adjustments Of the interest rate of the loan at regular intervals. Also known as a "variable rate mortgage" or a "floating rate mortgage".
Components of an Adjustable Rate Mortgage:
Initial rate: the initial rate charged on an ARM for a specified period, anywhere from three months to 10 years. The shorter the period, the lower the initial rate.
Interest Rate Index - An index used to calculate the rate of ARMs that is independent of the lender. As the index decreases or increases, the ARM does the same. Some common indices include 6-month or 12-month US Treasury bond rates or the Preferred Rate.
Margin - The number of percentage points added to an index rate to determine the current ARM rate.
For example, if the index rate is 5% and the margin is 2%, then the ARM rate is 7%.
Setting interval - How often the ARM frequency will be reset. The one-year adjustment interval is more common.
Rate Cap - Limits how much an ARM rate can change. The periodic cap limits how much a rate can change over a given setting interval. The lifetime cap limits the total rate adjustment over the life of a loan.
Payment Cap - Sets a dollar limit on how much a monthly payment can increase. This limits the change in the monthly payment of the mortgage but does not limit the interest rate charged. When rates are rising, less of the payment goes towards the principal and more towards the interest.
Negative amortization - A situation in which monthly payments are not sufficient to cover interest due on the loan. The unpaid interest is then added to the loan balance, which means that the borrower's balance grows each month instead of decreasing.
