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WhatAre ARMs Really About?
By Jules C. Hooker Published: 09/29/2009
Worrying about what kind of mortgage you want to take is hard enough, without having to decide on which interest rate index is going to be the deciding factor on what your interest rates on your Adjustable Rate home loan will be!
When we speak about the index for an ARM, we are talking about the instrument that the adjustments to the loan rate will be tied to. Today, banks use different indices, such as the rate on government debt, or the Fed Fund rate or the London Interbank Offer Rate(LIBOR).
You must initially understand that an ARM is a mortgage with an interest rate that moves up or down within a certain set period, and the movements are predicated upon the movements of the underlying index. One such instrument would be Certificates of Deposit-your mortgage rate would go up and down with the CD rate. ARMs have rate adjustment caps, so that the rate on your mortgage will only go up at certain intervals (every three or six months, for example), so that if the CD rate goes up, you may not have an increased rate for a few months, if your rate just adjusted recently. Of course, the opposite can happen, and if your rate has recently been readjusted at a high rate, and then the index moves down, you will not be able to take advantage of that until your next readjustment period.
ARMs can be tied to any number underlying instruments, such as the 90 day U.S. Treasury Bill. The Fed Funds rate is the most used index for ARMs. LIBOR is the London Interbank Offered rate, which is the rate that commercial borrowers pay each other for the use of funds.
Deciding upon which index is the one for you will depend on your own circumstances as well as your view of interest rate movements. If you would like a rate that is responsive to the interest rate market, you should choose the CD rate as your benchmark. Adjustable rate mortgages that use T Bills will adjust 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.
But in addition to these standards, new products are always been introduced on the mortgage market; an example would be the option ARM, that will let a borrower decide how much mortgage he is going to pay each month! The idea behind these loans is that they are basically interest only loans, so you have to pay that minimum, and then you can choose to pay more. Those using this option should be aware of negative amortization, because they may never repay any of the loan if they always choose the lowest amount.
This is a lot of information for the home buyer to digest, and the best solution is to talk to a professional mortgage broker who can explain it all and recommend the best course for you.