Section 7 _Most Common
ARM Terms:
Index
- The index of an ARM is the financial instrument that the loan
is "tied" to, or adjusted to. The most common indexes
are the 1-year Treasury Security, LIBOR (London Interbank Offered
Rate), Prime 6-month Certificate of Deposit (CD), 12-MAT (Moving
Treasuries Average) and the 11th District Cost of Funds (COFI).
Each of these indexes move up and down based on financial market
conditions. More details on these indexes appear below in our
discussion of MOST COMMON INDEXES.
Margin
- 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 (5.50% index plus 2.50% margin equals an 8.00% fully indexed
rate). Margins range from about 1.75% to 3.50%, depending on the
index, Loan to Value and borrower credit rating.
Interim
Caps - All ARMs carry interim caps. Interest rate
caps of six-months to a year are most common but some have caps
up to three years. Rate caps are a good thing when interest rates
are rising and a bad thing when rates are falling.
Payment Caps
- Some loans have payment caps instead of interest rate caps.
These loans reduce "payment shock" in rising rate markets,
but can also lead to deferred interest or "negative amortization."
The most common of these mortgage types caps your payments at
7.5% of the previous payment.
Lifetime
Caps - Most ARMs carry a lifetime cap or maximum interest
rate. The lifetime cap, which varies by loan program, have higher
margins with lower lifetime caps and, visa versa, mortgages that
carry low margins often have higher lifetime caps.
ARMs are available for both purchases and refinances.
As a rule, ARMs with indexes that are subject to rapid change
lets you take advantage of quickly falling interest rates. An
index that lags the market (such as the COFI mortgages) protects
you when rates quickly rise. Changes in the index are what change
your monthly payments.
Questions to Ask When Considering an Adjustable
Rate Mortgage:
- What would the interest rate be today if
the rate were fully adjusted, based on the current value of
the index?
- Is there a prepayment penalty?
- How long before the interest rate can adjust?
- By what amount can the rate adjust
at that time? At the next adjustment period?
Over the life of the loan?
