The Key to Understanding ARMs

You have a lot of choices to make in buying a house and deciding upon a mortgage, and in today's confusing loan world, you now also have to choose the index that you want for your Adjustable Rate Mortgage (ARM).

The index of an ARM (Adjustable Rate Mortgage) is the underlying standard upon which the adjustments will be made. Today, banks use different indices, such as the rate on government debt, or the Fed Fund interest or the London Interbank Offer Rate(LIBOR).

You must first understand that an ARM is a mortgage with an interest rate that moves up or down within a certain set period, and the movements are predicated upon the movements of the underlying index. One such instrument would be Certificates of Deposit-your mortgage rate would fluctuate up and down with the CD rate. ARMs have rate adjustment caps, which means that the rate on your mortgage will only go up at certain intervals (every three or six months, for example), so that when the CD rate goes up, you may not have an increased rate for a few months, if your rate just adjusted recently. But be aw are, however, that if you just readjusted at an increased rate, and your index rate goes down, you are stuck with the increased rate until the next adjustment period.

There are any number of ARM indices, and they include the CDs, LIBOR and government bonds mentioned. The Fed Funds interest is the most popular index for ARMs. Many of the international banks will employ the LIBOR as the index rate for mortgages.

How you decide upon the right index is dependent upon your particular circumstances and how you believe interest rates will change. If you have an ARM that uses CDs as its base, you can expect it to be very responsive to market moves. On the other hand, if your ARM is based on T Bills, it will react more slowly. Quickest of all in reaction time is the LIBOR, so if you feel that rates are falling and want to take advantage of every downward move, this is the one for you.

An option ARM is one in which the interest rate adjusts monthly and the payment adjusts every year, and the borrower is offered an "option" on how large a payment he would like to make. The options that are offered represent interest-only payments, and a lowest possible payment that can't be less than the interest-only payment. There is a real danger in option mortgages that the mortgage will end up with negative amortization, which means the mortgage balance increases instead of decreasing as it normally would.

With this dizzying choice in interest rate options for your mortgage, the best idea is to meet with a mortgage expert who can explain all of them to you and advise you best on your needs.
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