Initial Interest Rate
The initial interest rate is the introductory rate applied to an adjustable-rate mortgage (ARM), generally lower than the market rate to make the loan more attractive. This rate is fixed for an initial period, typically ranging from one month to several years, before it adjusts periodically based on an index plus a margin.
Examples
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Example 1: An adjustable-rate mortgage was originated at a 3% initial interest rate, even though mortgage interest rates were 4.5% at the time the loan was taken. It is likely that the interest rate will increase at the first adjustment date, even if the market interest rates remain stable.
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Example 2: A borrower secured a 5-year ARM with a 2.5% initial interest rate for the first five years. After five years, the interest rate will reset annually based on the chosen index rate (e.g., LIBOR or Treasury rate) plus a 2% margin.
Frequently Asked Questions (FAQs)
What happens when the initial interest rate period expires?
After the initial interest rate period expires, the interest rate adjusts at predetermined intervals based on the index specified in the mortgage terms plus a margin.
Are initial interest rates always lower than fixed mortgage rates?
Not necessarily. They are often lower to attract borrowers, but this is not always the case. It depends on the lender’s terms and current market conditions.
How frequently do the interest rates adjust after the initial period?
It varies by the mortgage’s terms; common intervals are annually or every six months. This should be outlined in the loan agreement.
Can the interest rate decrease after the initial period?
Yes, if the underlying index used for the ARM decreases, the interest rate could also decrease. However, many ARMs come with rate caps that limit how much the rate can change.
What is a teaser rate?
A teaser rate is an attractively low initial interest rate offered by lenders on ARMs to attract borrowers. This rate is usually short term and will adjust upwards after the introductory period ends.
- Adjustable-Rate Mortgage (ARM): A mortgage with an interest rate that may change periodically based on an index.
- Fully Indexed Rate: The interest rate on an ARM calculated by adding the index rate to the mortgage’s margin.
- Caps: Limits placed on the adjustments of interest rates in an ARM during any given period and over the life of the loan.
- Teaser Rate: An unusually low initial interest rate intended to attract borrowers, typically increasing after a short initial period.
Online Resources
References
- Investopedia. “Adjustable-Rate Mortgage (ARM).” Retrieved from https://www.investopedia.com/terms/a/arm.asp
- Consumer Financial Protection Bureau. “What is an adjustable-rate mortgage?” Retrieved from https://www.consumerfinance.gov/ask-cfpb/what-is-an-adjustable-rate-mortgage-arm-en-186/.
Suggested Books for Further Studies
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“The Mortgage Encyclopedia: The Authoritative Guide to Mortgage Programs, Practices, Prices, and Pitfalls” by Jack Guttentag
- An all-encompassing reference book addressing various mortgage types and common practices, including adjustable-rate mortgages.
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“Armageddon: What You Need to Know about ARMs” by often published by lenders or financial agents
- Understanding the intricacies of Adjustable-Rate Mortgages.
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“The Intelligent Mortgage Consumer” by John B. Allen
- A consumer-guidebook providing broader tips on making well-informed mortgage decisions.
Real Estate Basics: Initial Interest Rate Fundamentals Quiz
### What is an initial interest rate in an ARM?
- [x] The introductory rate applied to the loan for a set period before adjustments.
- [ ] The final interest rate of the loan.
- [ ] The interest rate applied to fixed-rate mortgages.
- [ ] The rate that applies only after the first rate adjustment.
> **Explanation:** The initial interest rate is the introductory rate applied to an adjustable-rate mortgage (ARM) for a specific period at the start of the loan.
### What tends to happen to the initial interest rate after the initial period expires?
- [ ] It permanently stays the same.
- [x] It adjusts periodically based on an index plus a margin.
- [ ] It automatically reduces to zero.
- [ ] It turns into a fixed rate forever.
> **Explanation:** After the initial period expires, the initial interest rate adjusts periodically based on a selected index plus an extra defined margin.
### Which of the following best defines a teaser rate?
- [x] An attractively low initial interest rate to lure borrowers.
- [ ] A penalty rate for late payments.
- [ ] An interest rate applied to loans that doesn't change.
- [ ] The standard rate applied to all loan types.
> **Explanation:** A teaser rate is an attractively low initial interest rate used by lenders to entice borrowers, often applied temporarily.
### What elements affect the adjustments of an ARM's interest rate?
- [x] Index and margin.
- [ ] Borrower’s credit score alone.
- [ ] Fixed interest rate caps.
- [ ] Lender’s discretion.
> **Explanation:** The adjustments are typically influenced by the chosen operation index (like LIBOR) in conjunction to a fixed margin detailed in the loan agreement.
### How can a borrower be protected from significant rate increases in an ARM?
- [ ] By buying insurance.
- [ ] By assuring multifamily property use.
- [x] Through interest rate caps.
- [ ] By continuously refinancing.
> **Explanation:** Interest rate caps are mechanisms placed to limit the maximum increase of interest rates during intervals and total life-term of the loan.
### After the initial interest rate period on an ARM, when does usually next rate adjustment takes place?
- [ ] At the desired timing of a borrower.
- [ ] Every five years.
- [x] Periodically, e.g., annually or every six months.
- [ ] Never again.
> **Explanation:** The adjustment rate period happens periodically like annually or semi-annually according to the terms agreed upon the loaning process.
### Why might a borrower choose an ARM with initial lower interest rates?
- [ ] To avoid balloon payment.
- [x] To afford lower monthly payments initially.
- [ ] To lock in the interest rate.
- [ ] To handle tax increment considerations.
> **Explanation:** Borrowers select ARMs often as it offers lower monthly payment initially under the introductory lower-rate phase making immediate financing affordable.
### What does "fully indexed rate" imply in an ARM?
- [ ] Value by which the rate is capped continuously.
- [x] Interest rate is combined index value and margin after original period.
- [ ] Maximum and Minimum allowable interest rates.
- [ ] Exclusive loan-specific incentive locked-in at youthful credit rating.
> **Explanation:** Full indexed rate refers indicating the new payable mortgage amount after introductory tenure, combined sum from selected index and loan’s margin.
### In the ARM termed "Caps," what is the key purpose of introducing a cap?
- [x] Restricts the magnitude of interest rate increments.
- [ ] Directly counters balance down payment for borrower.
- [ ] Helps fixed early exit financial injections.
- [ ] Stabilizes past property income history.
> **Explanation:** Caps implicate certain maximum extend in interest rate fluctuations leading balanced and relatively predictable mortgage payments over loan term.
### Identifying significant drawback concerning ARM despite primarily low initial rates?
- [ ] A period of immediate expensive servicing by repayment part.
- [ ] Smaller length and possible tax increments.
- [x] Uncertainty in rate-pattern post initial period causing higher future charges.
- [ ] Associated Scrutiny Reports routinely generated.
> **Explanation:** Despite handing an affordable initial edge, primary low rate, ARM veils path offering rate-unpredictability, hence poses risk towards future possibly higher monthly responsibility.
