Adjustable Rate Mortgages
An adjustable rate mortgage (ARM) is one where the interest rate on the note adjusts based on an index value on a predetermined date. The actual interest rate that is charged on the loan is called the fully indexed rate and is made up of an index plus a margin. The margin remains constant throughout the life of the loan and can be thought of as the lenders profit margin.
The index that is used will vary from loan to loan, but the most common are:
London Interbank Offered Rate (LIBOR)
12 Month Treasury Average (MTA)
11th District Cost of Funds Index (COFI)
Constant Maturity Treasury (CMT)
The best way to determine which index is best for you is to look at the current interest rate environment and consider how each of the indicies have performed in the past. For historical charts and more information on each index please visit http://mortgage-x.com/general/mortgage_indexes.asp.
Generally speaking ARMs are considered to be riskier than fixed rate mortgages, and as a result, they are offered at lower interest rates. To limit some of the increased risk, adjustable rate mortgages come with caps. A cap limits how much an interest rate can adjust from one period to the next. Lenders will typically quote caps in the form 2/2/6 or 5/2/5. The first number correlates to how much the interest rate can change on the first adjustment, the second number correlates to how much the interest rate can change durring subsequent adjustments, and the last number correlates to how much the interest rate can change over the life of the loan. Following the first adjustment, most adjustable rate mortgages adjust again every 6 or 12 months.
In recent years, hybrid ARMs have become very popular. These loans have a fixed rate period, which is usually 1, 3, 5,or 7 years long and then becomes adjustable after that. It is common for people in the industry to call these, for example, 3/1 ARMs. A 3/1 ARM means the initial interest rate is fixed for 3 years and then adjusts each subsequent year. The interest rates on these loans tend to increase as the length of the fixed period increases but still tend to be lower than fixed rate interest rates. These loans are a great option for people that are relatively certain how long they will be in the home. Hybid ARMs also work well for people who expect their income to rise in the future, which can offset an increase in their monthly payment in case interest rates increase when the loan becomes adjustable.