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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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