Adjustable Rate Mortgage
Adjustable Rate Mortgage also referred to as ARM is a mortgage loan wherein the rates of interest vary and it is generally linked to the changes in an economic index. Simply put, they are home loans with interest rates that fluctuate in accordance with the changes in the primary indices such as the Treasury bill rate or the prime rate. Interest rates or payments on the note are periodically adjusted depending upon the variety of indices. The primary reason behind the interest rate adjustment is to bring the interest rate on the mortgage in conformity with the market rates.
Index
Interest rate on adjustable rate mortgage is determined by some market index. Index helps the lenders to measure rate variations and determine the interest rate on the mortgage. Each adjustable rate mortgage is related to a specific index. The most common indices are interest rates on one, three, and five-year year constant maturity Treasury securities, the London Interbank Offered Rate (LIBOR) and Cost of Funds Index (COFI).
Market index used for determining the interest rate on adjustable rate mortgage is a technicality, but it has a significant affect on the manner in which the payment amounts changes. You can always seek an explanation from your lender as to why you have been given an adjustable rate mortgage based on a given index. To reap optimum gains, search for an ARM that is related to an index, which has remained fairly stable over the past few years.
Interesting features of Adjustable Rate Mortgage
While lending, a few creditors may apply their own cost of funds as an index rather than fixing interest rates in response to the changes in other indices. This is primarily done by the lender with the objective of getting a steady margin, whose cost of funding will usually be in line with the index. Therefore, there is no fixed rate of money that the borrower needs to pay to the lender. Payment rate is subject to variations that results from changes in the money market.
Given that ARM involves a repayment method where the borrower do not need to pay a fixed amount of money and interest rate depends upon changes in the market rates, this mortgage should not be confused with the graduated payment mortgage, which involves changing payment amounts but a fixed interest rate. In case of adjustable rate mortgages, there is no fixed interest rate on the mortgage. It is adjusted up or down with the interest rates in the marketplace. ARMs are unique since mortgage payments amounts are decided in part by the interest rate on the loan. With the rise in the interest rates, the monthly payment amounts on mortgages also rises. Similarly, with the fall in the interest rates, payments also plunge.
Why go for Adjustable Rate Mortgage
One of the reasons as to why one should consider ARMs is that it permits borrowers to get lower initial payments if they are ready to assume the risk of interest rate fluctuations. The bank may provide with a lower initial rate on the basis of the risk that interest rates could rise in the future. It is unlike the situation in fixed rate mortgage where the bank takes the risk. In case where the rates rise, the bank has to provide loan at a below-market rate when you have a fixed rate mortgage. Alternatively, you can get a better rate, if rates fall. In ARMs, borrower is shielded from incurring huge losses in case where there are drastic changes in the interest rate by a maximum interest rate limit called 'Ceiling'.