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Several adjustable rate mortgages are
available to homeowners and they include 6-Month Certificate of Deposit
ARM, 1-Year Treasury Spot ARM, 6-Month Treasury Average ARM, and the
12-Month Treasury Average ARM. An ARM that reacts quickly to the market
will allow the borrower to benefit from falling interest rates. An ARM
that lags the market will allow the borrower to take advantage of lower
rates when rates being to increase.
There are
several aspects of ARMs that impact interest rates including the index,
margin, interim caps, and payment caps. The index of an ARM is the
financial instrument that the loan is linked to and indexes move up and
down with the market. The margin is added to the index to determine the
interest that the borrower will pay. Caps, such as the interim cap,
protect borrowers against rising interest rates. Payment caps, on the
other hand, place a maximum on the amount a borrower must pay. This
type of cap also protects against payment shock associated with rising
interest rates.
The index of
an ARM is the financial instrument that the loan is "tied" to, or
adjusted to. The most common indices, or, indexes are the 1-Year
Treasury Security, LIBOR (London Interbank Offered Rate), Prime,
6-Month Certificate of Deposit (CD) and the 11th District Cost of Funds
(COFI). Each of these indices move up or down based on conditions of
the financial markets.
The margin
is one of the most important aspects of ARMs because it is added to the
index to determine the interest rate that you pay. The margin added to
the index is known as the fully indexed rate. As an example if the
current index value is 5.50% and your loan has a margin of 2.5%, your
fully indexed rate is 8.00%. Margins on loans range from 1.75% to 3.5%
depending on the index and the amount financed in relation to the
property value.
All adjustable rate loans carry
interim caps. Many ARMs have interest rate caps of six-months or a
year. There are loans that have interest rate caps of three years.
Interest rate caps are beneficial in rising interest rate markets, but
can also keep your interest rate higher than the fully indexed rate if
rates are falling rapidly.
Some
loans have payment caps instead of interest rate caps. These loans
reduce payment shock in a rising interest rate market, but can also
lead to deferred interest or "negative amortization". These loans
generally cap your annual payment increases to 7.5% of the previous
payment.
Almost all ARMs have a maximum
interest rate or lifetime interest rate cap. The lifetime cap varies
from company to company and loan to loan. Loans with low lifetime caps
usually have higher margins, and the reverse is also true. Those loans
that carry low margins often have higher lifetime caps.
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