The Key to Understanding ARMs
2:57 AM
In addition to the many decisions you have to make when you are choosing a home loan, such as whether to go fixed or floating rate, how much down payment to make and how many points to pay, lenders have further complicated matters by offering a wide range of choice of indexes for ARMs (adjustable rate mortgages).
When we speak of the "index", we are speaking of the base financial instrument that the adjusting rates will be based upon. Various indices are used, including government treasury instruments, the Fed Fund rate or LIBOR.
Interest rates on ARMS change, upwards or downwards, based on how general rates are moving, which is shown in the movement of the underlying index rate. For example, if you pick the CD rate as your index, when CD rates increase, your mortgage rate will go up. Adjustable rate mortgages have adjustment caps, which means that the interest rate can only be adjusted at certain periods, even if the underlying interest rate goes up more frequently; this can be an advantage if you just readjusted and then rates move up. Of course, the opposite can happen, and if your rate has just been readjusted at a high rate, and then the index moves down, you cannot take advantage of that until your next readjustment period.
There are any number of ARM indices, and they include the CDs, LIBOR and government bonds mentioned. The Fed Funds interest is the most used index for ARMs. LIBOR, the London Interbank Offered Rate, is another popular index, and is the rate used by international companies to borrow.
How you decide upon the correct index is dependent upon your particular circumstances and how you believe interest rates will change. CD ARMs change every six months, for example, and therefore react more quickly to interest rate changes. On the other hand, if your ARM is based on T Bills, it will move more slowly. LIBOR is the index that moves the most frequently and the most rapidly, so if you want to take frequent advantage of the downward level of decreasing rates, this is the one for you.
An option ARM is one where the interest rate adjusts monthly and the payment adjusts every year, and the borrower is offered an "option" on how large a payment he would like to make. There is a minimum payment that covers the interest (so the bank gets its money) and then the other options will pay off some portion of equity. There is a real danger in option mortgages that the loan will end up with negative amortization, which means the mortgage balance increases instead of decreasing as it normally would.
With this dizzying choice in interest rate scenarios for your mortgage, the best idea is to meet with a mortgage expert who can explain all of them to you and advise you best on your needs.
When we speak of the "index", we are speaking of the base financial instrument that the adjusting rates will be based upon. Various indices are used, including government treasury instruments, the Fed Fund rate or LIBOR.
Interest rates on ARMS change, upwards or downwards, based on how general rates are moving, which is shown in the movement of the underlying index rate. For example, if you pick the CD rate as your index, when CD rates increase, your mortgage rate will go up. Adjustable rate mortgages have adjustment caps, which means that the interest rate can only be adjusted at certain periods, even if the underlying interest rate goes up more frequently; this can be an advantage if you just readjusted and then rates move up. Of course, the opposite can happen, and if your rate has just been readjusted at a high rate, and then the index moves down, you cannot take advantage of that until your next readjustment period.
There are any number of ARM indices, and they include the CDs, LIBOR and government bonds mentioned. The Fed Funds interest is the most used index for ARMs. LIBOR, the London Interbank Offered Rate, is another popular index, and is the rate used by international companies to borrow.
How you decide upon the correct index is dependent upon your particular circumstances and how you believe interest rates will change. CD ARMs change every six months, for example, and therefore react more quickly to interest rate changes. On the other hand, if your ARM is based on T Bills, it will move more slowly. LIBOR is the index that moves the most frequently and the most rapidly, so if you want to take frequent advantage of the downward level of decreasing rates, this is the one for you.
An option ARM is one where the interest rate adjusts monthly and the payment adjusts every year, and the borrower is offered an "option" on how large a payment he would like to make. There is a minimum payment that covers the interest (so the bank gets its money) and then the other options will pay off some portion of equity. There is a real danger in option mortgages that the loan will end up with negative amortization, which means the mortgage balance increases instead of decreasing as it normally would.
With this dizzying choice in interest rate scenarios for your mortgage, the best idea is to meet with a mortgage expert who can explain all of them to you and advise you best on your needs.
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