What is an adjustable-rate loan?
Adjustable-rate loans vary, but they all share one common factor--the lender can change some aspect of the terms of the loan during the life of the loan. The specific type of adjustable mortgage is tied to whether the change is in the rate of interest, the amount of payment, or the length of time for repayment.
Adjustable-rate loans include:
Adjustable-rate mortgages (ARMs). These loans typically offer a lower-than-market interest rate in the first year or first few years. The future interest rate, usually adjusted annually, is tied to an index that may move up or down but is not under the control of the lender. The index might be one-year Treasury bills (the T-bill rate) or some other rate that reflects the changes in interest rates.Note that the rate is tied to the index, but it is not the same as the index. The mortgage might specify, for example, that the future rate would be two points above the average T-bill rate. Typically, ARMs are adjusted once a year on the anniversary date of the loan. Additionally, ARMs usually have a provision for a cap, that is, the highest rate that could be charged. Some loans may include a minimum rate, or floor, as well.
Convertible ARMs. These loans usually offer a conversion factor that allows the borrower to convert to a fixed-rate loan at a specified period of time. For example, a convertible ARM could allow the borrower the option to convert to a fixed-rate loan once a year over the first five years of the loan. The interest rate to be paid upon conversion might also be tied to an index.
Renegotiable-rate mortgage (rollover). These loans typically set the interest rate and monthly payments for several years and then allow both the rate and the principal payments to be changed depending on general market conditions. If the new terms are unacceptable, the borrower can pay the loan in full or refinance at prevailing interest rates.
Graduated payment mortgage (GPM). With this type of loan, typically sought by young buyers who expect their incomes to rise, the payments are low in the first couple of years and gradually rise for five to ten years.
Shared-appreciation mortgage. These loans offer lower-than-market rates of interest and low payments in exchange for a lender's share in appreciation of the property. Usually, the lender will require that its share of equity be turned over when the home is sold or at a specified date set out in the loan agreement.
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