Adjustable Rate Mortgage
An adjustable rate mortgage's interest rate
varies over the life of the loan. The interest rate at the beginning of the loan
will often be a comparatively low interest rate, known as the introductory or teaser rate. This
teaser rate will hold for a certain time period. After the teaser rate
period is over the interest will vary every 6 to 12
months, although some can vary every month.
Interest Rate = Index Rate + Margin
The actual interest rate varies
based on how interest rates are doing in general. If interest rates are up then
the ARM will also be up, and if interest rates are down the ARM will also be
down. When the interest rate of an ARM changes so will the monthly payment made,
thus there is a risk that the monthly payment will become larger. Adjustable
rate mortgages will start out with a lower interest rate compared to a fixed rate
mortgage, so you can borrow more, however it is important to keep in mind that
interests rates can go up!! As well as your monthly payment!!
Getting an ARM can
save money if you know that you can afford the higher payments in the future. If
you purchase when interest rates are high then ARM will save money because of
lower interest rates at the start. Then when interest rates go down so will the
rate on the ARM. Also if a refinance is not possible then you will still be able
to reap the benefits of falling interest rates. Another benefit of an ARM
mortgage is that they are usually assumable, which means they can be transferred
from one person to another. This is a good feature to have especially if
interest rates are very high, as they were in the 1980's, and you need to sell.
However, some ARM's may have clauses that only allow them to be assumed once.
Determining the Interest Rate of an Adjustable Rate Mortgage
After the initial
teaser rate period is over, the interest rate will adjust. The interest rate of an ARM is based on the
The index is a measure of interest rates in general. Rates of indexes vary
in response to changes in interest rates. Some of the more common indexes are:
Treasury Bills (T- Bills)
Based on what the United States Federal Government
pays on it's debt. There are both 6 month and 12 month Treasury Bills. Treasury
Bills tend to respond quickly to the interest rate changes and so are good when
interest rates are falling, however they will be bad if interest rates are
Certificate of Deposits (CDs)
ARM's can be based on the average
banks pay on 6 month Certificate of Deposits. Certificate of Deposits are
interest baring notes issued by banks and credit unions. These are also volatile, but they
aren't as volatile as Treasury Bills. The rates for Certificate of Deposits are
usually slower to increase, but faster to decrease.
11th District Cost of Funds Index (CoFI)
The CoFI is the weighted average interest rate paid by the 11th Federal Home Loan Bank District
on checking and savings accounts.
ARMs tied to the CoFI tend to respond slower to changes in interest rates, both up and down.
Because of the slower response of the CoFI, ARM's will usually start at higher
interest rates than ARMs with other indexes. Despite the higher rates, the CoFI
provides the most protection against sudden rises in interest rates. In the case
of falling interest rates, the option to refinance is also there.
London Interbank Offered Rate Index (LIBOR)
The LIBOR is the average interest
rates large international banks charge to borrow American dollars in London's
financial market. The index tends to be volatile similar to T-Bills and CD's
index. This index is used by foreign investors who purchase American Loans as
investments. In order to choose the right index, you should ask yourself how a
particular index has performed in the last 5-10 years. Although past performance
doesn't guarantee future values, it will give you a bases to judge the indexes.
In addition to the index an ARM interest rate is
determined by the margin. The margin is the profit added by the bank. Usually it
is around 2.5%, but it depends on the index that has been used and the lender.
After the teaser rate period is over, the loan will assume the full index rate,
which is index + margin. For example, let's say you have
taken out an ARM with an initial teaser rate of 2%. Now the teaser rate period
rate is over, and it will assume the full index rate. Assuming the loan is tied
to the one-year T-Bill index, which is at 2.7% and the loan has a margin of 2.5%
the full index rate is
Full index rate = Index rate + Margin
Full index rate = 2.7% + 2.5% = 5.2%
Notice the rather dramatic jump in interest rate that can occur when the initial
teaser period is over. ARM rates usually adjust 6-12 month, but some can adjust
every month. The lender will inform you every time the rate is changed. The more
frequently the rate changes the more risky it is, however it is likely the rate
will be lower since the bank can just wait for interest rates to increase.
Similarly the less frequently the rate adjusts the less risky it is, and the rate
will likely be higher, since the bank can't change the rates as fast. There are
limits on rate adjustments, known as rate caps. There are two types of rate
This cap limits the maximum change in interest rate that can happen in an adjustment
interval, usually for 6 months they will be ± 1%, and for 12 months they will be
In many cases the initial adjustment from the teaser rate to the
full index rate is not subject to a periodic rate cap, and can result in a
rather dramatic interest rate increase. Also keep in mind that
when rates fall rapidly the ARM may not respond as fast as you would
like, since the periodic rate cap applies to increases and decreases.
These caps limit the absolute interest rate on the loan. Interest rate
on the loan will never go above the maximum set by the cap. Make sure
you are able to afford the monthly payments on this worst case, highest
interest rate. This way you won't be facing default if higher payments
Negative amortization occurs when the payment on the loan
does not cover the interest, and thus the remaining amount is added back to the
loan principal, and now more money is owed than before.
Some ARM will limit maximum monthly payments instead of
the maximum interest rate, the problem here is that even with maximum monthly payment, it might
not cover the interest on the loan, thus leading to negative amortization.
Make sure to specifically ask if the loan has the potential for negative amortization.
Adjustable rate mortgages can save you money in the long run. However, they can also
cost you more money if interest rates increase dramatically. ARMs are best suited for
those who can afford the higher payments when interest rates go up, but want to take
advantage of the potentially lower payments.
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