WhatAre ARMs All About?
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 speak of the “index”, we are talking about of the base financial instrument that the changing rates will be based on. Today, banks use various indices, such as the rate on government debt, or the Fed Fund interest or the London Interbank Offer Rate(LIBOR).
The basic idea of an ARM is that the interest on the loan is adjusted up or down, periodically, based on a chosen signal interest rate that is indicative of interest rates in general. If your index is CDs, and CDs go up, your mortgage rate goes up. An additional feature of an ARM is that there is an adjustment cap, which prevents the interest from moving up or down too frequently, even if the index does; sometimes this can be an advantage if you just adjusted and then rates move upwards. 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 Fund rate is what banks pay to the Federal Reserve Bank to borrow money. Many of the international banks will use the LIBOR as the index rate for mortgages.
How you decide upon the correct index is dependent upon your particular circumstances and how you believe interest rates will move. CD ARMs adjust every six months, for example, and therefore react more readily to interest rate changes. ARMs that have the Tbill interest as the index do not move as frequently as the CD index. LIBOR is the index that moves the most often and the most quickly, so if you want to take frequent advantage of the downward level of decreasing rates, this is the one for you.
But in addition to these standards, new products are always been introduced on the market; an example would be the option ARM, that will let a homeowner decide how much mortgage he is going to pay each month! There is a minimum payment that covers the interest (so the bank gets its money) and then the other options will pay off some portion of equity. There is a real danger in option mortgages that the mortgage will end up with negative amortization, which means the mortgage balance goes up instead of decreasing as it normally would.
With this dizzying choice in interest rate options for your mortgage, the best option is to meet with a mortgage consultant who can explain all of them to you and advise you best on your needs.
