Adjustable rate Mortgages (ARMs) are a special type of home loan.
The interest rate you are charged for the money you
borrow changes or adjusts periodically
based on changing economic conditions. Accordingly, your monthly
payment may go up or down. Lenders usually charge lower initial interest
rates for ARMs than for fixed-rate loan because you are sharing the risk
if interest rates go up. ARMs, are therefore less expensive especially in the
beginning than fixed rate loans. This may mean that you can qualify for a
larger loan if you select an ARM. Be careful! You don't want to select a
loan that could become burdensome
in the event interest rates increase substantially in the future.
How Interest Rates Are Established
ARM interest rate changes are tied to changes in an index
rate. An index rate usually goes up or down with the general
movement of interest rates. If interest rates move up, so will your ARM
interest rate, and in most
circumstances, so will your monthly payments. Likewise, if interest rates
go down, your monthly payment may go down. There are a number of indices
used for ARMs.
Each one has distinct market characteristics and fluctuates differently.
- Six Month Certificate of Deposit (CD) Spot Index. This index is the weekly
average of the secondary market interest rate paid on six month negotiable
Certificates of Deposit. This index is generally considered to react quickly to
change in the market.
- One Year Treasury Spot Index. This index is the weekly average yield
on United States Treasury Securities adjusted to a
constant maturity of one year.
The index, reacts more slowly than the CD index, but more quickly than the
Eleventh District Cost of Funds index or the Treasury Twelve Month
Average index.
- Treasury Twelve Month Average Index. This index is the
twelve-month average of monthly yields on actively traded United
States Treasury Securities,
adjusted to a constant maturity of one year. Because this index
generally reacts more slowly in fluctuating markets, adjustments in
your ARM interest rate will lag behind some other market indicators.
- Eleventh District Cost of Funds Index. This index is the
monthly weighted average cost of savings, borrowings and advances of
members of the Federal Home Loan Bank of San Francisco. Because this index
generally reacts slowly in fluctuating markets, adjustments in
your ARM interest rate will lag behind (another) market indicators.
- LIBOR This index is the London Interbank Offer Rate. This is an
international index which follows the world economic condition. It is
usually a six month or twelve month average.
What is a Margin?
To establish your ARM interest rate, percentage points are added
to the index rate you choose. These percentage points are called
margin. The margin is established
by the lender and stays the same for the term of
the loan. Your ARM interest rate will be adjusted periodically. Your ARM
interest rate is fully indexed when
it equals the index plus the margin. The size
of the margin is an important consideration when comparing ARM loan options.
Why ARM Interest Rates are Lower than Fixed Rates?
Remember, interest rates are usually lower for ARM
loans of the same amount. With a fixed rate loan, you are paying for the
security of knowing that your interest rate
(and your monthly payment) won't change in the future. When shopping for a home
loan, you should compare the fully indexed ARM rate with available fixed rates.
Interest Rates Are Sometimes Different than Fully Indexed Rate.
If the initial interest rate is lower than the
index plus margin, it is called a discounted rate. If the initial interest
rate is higher than the index plus the
margin, it is called a premium rate. The size of the discount or premium is the
difference between the initial interest rate
plus the margin. Although some lenders use the lower initial interest
rate to approve your loan in the case of a discount, you should consider
your ability to afford payments after the discount period ends.
Depending on the amount of the discount, you may be charged additional
points. After an initial ("introductory") period, the ARM
rate may increase significantly.
The initial period is usually not very long, and higher payments later
on may make up for this initial discount.
Sometimes the seller pays a fee to the lender or into escrow in
order to give you lower loan payments during the initial discount
period. This is referred to as a seller buydown. However, you remain
liable for the entire amount of the payment in the event the seller's share
becomes unavailable for any reason. Keep in mind, the seller may increase
the purchase price to cover the fee to the lender for the buydown. In such
a case, you will be covering this cost as part of the cost of
the house.