Find Out The Truth About ARMs
In addition to all of the other decisions you have to make when you are choosing a mortgage, 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 talk about the index for the ARM, we are speaking about the instrument that the adjustments to the loan rate will be tied to. These indices may be such things as the T-Bill rate, the rate of Federal Funds, or rates based on LIBOR.
Interest rates on ARMS adjust, upwards or downwards, based on how general rates are moving, which is shown in the movement of the underlying index rate. If your ARM is tied to the CD rate, and the bank’s CD rate goes up, your interest rate will likewise go up. ARMs have rate adjustment caps, which means 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. This can be a disadvantage if you have just readjusted, and afterwards there is a downward movement, however.
ARMs can be tied to any number underlying instruments, such as the 90 day U.S. Treasury Bill. The Fed Funds rate is one of the most popular basis for ARMs. LIBOR, the London Interbank Offered Rate, is a very popular index, and is the rate used by international companies to borrow.
The index is a personal choice, based on the individual mortgage, and how the borrower feels interest rates will be heading. If you have an ARM that uses CDs as its index, you can expect it to be very responsive to interest rate moves. Rates on Treasury instruments such as the Treasury Bill move more slowly than CDs, and so will react more less to interest rate changes. Quickest of all in reaction time is the LIBOR, so if you feel that rates are falling and want to take advantage of each downward move, this is the index for you.
But in addition to these standards, new products are always been introduced on the mortgage market; an example would be the option ARM, which lets a homeowner decide how much mortgage he is going to pay each month! Of course, there is a minimum, normally the amount of interest, so the bank can guarantee its return, and then the balance goes toward the mortgage principle. One of the big issues with an option mortgage is that you can end up with an increasing instead of decreasing mortgage; this is also known as negative amortization.
This is a lot of information for the borrower 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.