ARMs Are Not Too Hard to Understand
As if there were not enough decisions to make when you are buying a house and getting a mortgage, lenders now have such a wide rang of ARMs (adjustable rate mortgages) and the borrower even has to decide upon the index upon which the ARM will be based!
When we speak of the “index”, we are talking about of the base financial instrument that the adjusting rates will be based upon. These indices may be such instruments as the T-Bill rate, the rate of Federal Funds, or rates based on LIBOR.
The basic concept of an ARM is that the interest on the loan is adjusted up or down, on a periodic basis, based on a chosen underlying interest rate that is indicative of interest rates in general. For example, if you chose the CD rate as your index, when CD rates increase, your mortgage rate will go up. An additional feature of an ARM is that there is an adjustment cap, which prevents the interest from moving up or down too frequently, even if the index does; sometimes this can be an advantage if you just adjusted and then rates move upwards. But be aw are, however, that if you just readjusted at a higher rate, and your index rate goes down, you are stuck with the higher rate until the next adjustment period.
Your ARM may be linked with the Treasury Bill rate, which is the rate the US Government pays on its 90 day investments. Another index that is frequently used is the Federal Funds Rate. LIBOR, the London Interbank Offered Rate, is another popular index, and is the rate used by international companies to borrow.
Deciding upon which index is the one for you will depend on your own situation as well as your view of interest rate movements. If you prefer a rate that is responsive to the interest rate market, you would choose the CD rate as your benchmark. On the other hand, if your ARM is based on T Bills, it will react more slowly. LIBOR is one of the quickest moving indices, so if you want to take advantage of quickly falling interest rates, this is the one to use.
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 wants to make. Of course, there is a minimum, usually the amount of interest, so the lender can guarantee its return, and then the balance goes toward the loan. Be warned that minimum payment option can result in an increasing, rather than decreasing mortgage, a phenomenon known as negative amortization.
This is a lot of information for the home buyer to digest, and the best solution is to consult with a professional mortgage broker who can explain it all and recommend the best solution for you.
