A:

An adjustable rate mortgage (ARM) is a type of mortgage that has a fixed interest rate for a certain time period at the beginning of the mortgage, which then becomes a floating interest rate according to an index (called a reference rate). This reference rate might be the six-month LIBOR, or the six-month Treasury yield, plus a certain spread, called a margin.

Both 2/28 ARM, and 3/27 ARM mortgages have 30-year amortizations. The main difference between these two types of ARMs is the length time for which their interest rates are fixed and variable. Other than this, these two mortgages are the same, aside from any contractual differences that may arise between the various lenders.

In a 2/28 ARM, the '2' represents the number of years the mortgage will be fixed over the term of the loan, while the '28' represents the number of years the interest rate paid on the mortgage will be floating. Similarly, in a 3/27 ARM, the interest rate is fixed for three years and floats for the remaining 27-year amortization. The margin that is charged over the reference rate depends on the borrower's credit risk as well as prevailing market margins for other borrowers with similar credit risks.

Sometimes, the initial fixed interest rate in an ARM is referred to as a teaser rate. This is because the borrower may advertise that it's offering ARM loans with lower rates than market fixed-interest rates. This entices borrowers to lock themselves into an ARM, such as a 2/28 or a 3/27. After a period of time, the initial interest rate will climb until it reaches the full indexed rate. This enables the lender to charge a large margin over the reference rate and high fees for settling the loan early.

Furthermore, 2/28 and 3/27 ARMs are considered to be subprime mortgages, which means they are extended to individuals who are of a higher credit risk than borrowers with a better credit score, higher down payment, more consistent employment history, higher loan to value ratio and who have no history of missed payments.

Usually, participants in these types of adjustable rate mortgages are individuals who wish to take advantage of a lower fixed interest rate over the initial term and then refinance their mortgages prior to the commencement of the floating interest rate period. However, what they do not realize is that there is often a high service fee for refinancing an ARM or paying the loan off early. Be sure to know the caveats, such as prepayment penalties and any refinancing service charges, in your ARM contract before you make any such transactions.

(For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.)

To learn more about adjustable rate mortgages, please read Mortgages: Fixed Rate Versus Adjustable Rate and ARMed And Dangerous.

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