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The Secret to Understanding ARMs
Worrying about what kind of mortgage you want to take is difficult enough, without also deciding on which interest rate index is going to be the deciding factor on what your interest rates on your Adjustable Rate mortgage will be!
When we talk about the index for an ARM, we are talking about the standard 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 interest or the London Interbank Offer Rate(LIBOR).
Interest rates on ARMS change, upwards or downwards, based on how general rates are moving, which is reflected in the movement of the underlying index rate. One such instrument would be Certificates of Deposit-your loan rate would fluctuate up and down with the CD rate. 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 often; this can be an advantage if you just readjusted and then rates move up. By the same token, if your adjustment is scheduled to take place immediately after the CD rate increased, you will have that rate for a while, even if the CD rate comes back down in the meantime.
The list of instruments that ARMs can be tied to reads like alphabet soup today, from CDs to LIBOR. The Fed Funds rate is another very popular basis for ARMs. LIBOR is the London Interbank Offered rate, which is a rate that commercial borrowers pay each other for the use of funds.
How you decide upon the right index is dependent upon your particular situation and how you believe interest rates will change. If you prefer a rate that is responsive to the interest rate market, you should choose the CD rate as your index. Adjustable rate mortgages that use T Bills tend to change more slowly. One of the fastest indices to change is the LIBOR, so if you want your interest rate to move often, because you think rates are falling, this is a good choice.
As we said, new products are introduced each day, and one of the newest it the option ARM, which allows the borrower to choose how much he wants to pay on his mortgage each month. The mechanism behind these loans is that they are basically interest only loans, so you have to pay that minimum, and then you have the choice to pay more. Be warned that minimum payment option can result in an increasing, rather than decreasing mortgage, a concept known as negative amortization.
With this dizzying choice in interest rate options for your mortgage, the best option 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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