WhatAre ARMs Really About?
As if there were not enough decisions to make when you are purchasing a house and getting a mortgage, lenders now have such a wide rang of ARMs (adjustable rate mortgages) and the borrower even has to choose the index upon which the ARM will be based!
The index of an ARM (Adjustable Rate Mortgage) is the financial standard upon which the rate changes will be made. Today, banks use different indices, such as the rate on government bonds, or the Fed Fund rate or the London Interbank Offer Rate(LIBOR).
The rate on an ARM is adjusted periodically upwards, or downwards, based upon the movement in the general interest rate environment, but tied to a specific instrument. If your index is CDs, and CDs go up, your interest rate increases. An additional feature of an ARM is that there is an adjustment cap, which prevents the interest from moving up or down too often, even if the index does; sometimes this can be an advantage if you just adjusted and then rates move upwards. This can be a disadvantage if you have just readjusted, and then there is a downward movement, however.
The list of instruments that ARMs can be tied to reads like alphabet soup nowadays, from CDs to LIBOR. The Fed Funds rate is the most popular index for ARMs. Another popular index used by many is the LIBOR, or the London Interbank Offered Rate, which highly rated international companies pay to borrow.
How you decide upon the correct index is dependent upon your particular situation and how you believe interest rates will move. CD ARMs change every six months, for example, and therefore react more quickly to interest rate changes. Adjustable rate mortgages that use T Bills will adjust more slowly. Fastest 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.
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. Of course, there is a minimum, normally the amount of interest, so the lender can guarantee its return, and then the balance goes toward the mortgage principle. 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 borrower 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.
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