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Variable or adjustable loan is a loan whose interest rate, and
accordingly monthly payments, fluctuate over the period of the loan.
With this type of mortgage, periodic adjustments based on changes in a
defined index are made to the interest rate. The index for your
particular loan is established at the time of application.
Well known indices include :
- 1. Treasury Security Indexes -- Yields on
United States Treasury Securities adjusted to constant maturities.
When using Treasury Securities, the ARM's adjustment period is
usually the same as the security's constant maturity.
- 2. Treasury Bills -- Commonly called T-bills
they come in denominations of 3 months, 6 months and 1 year.
Depending on which three of these security index schedules you
choose, the interest rate on your Adjustable Rate Mortgage (ARM)
will adjust once every six months, once each year, or once every
three years.
- 3. London Inter Bank Offering Rates (LIBOR) --
Interest rates at which international banks lend and borrow funds in
the London interbank market.
- 4. Certificate of Deposit Indexes -- Average
rates that you get when you invest in a 1- , 3- or 6-month CD.
- 5. 11th District Cost of Funds Index (COFI) --
This index reflects the weighted-average interest rate paid by 11th
Federal Home Loan Bank District savings institutions for savings
accounts and other sources of funds. ARMs based on this index can
adjust every month, every six months, or every year.
- 6. Prime Rate -- An interest rate offered to
banks best customers.
Historical and current values for some ARM's
indexes are available. In the H15 Federal Reserve statistical release
and in business newspapers.
New interest rate = index + margin
The margin is fixed percentage points added to the index to compute the
interest rate. The result will then be rounded to the nearest one-eighth
of a percent.
Example:
- The index is 5.3% and the margin is 2.5%,
- then the new interest rate = 5.3% + 2.5% =
7.8%.
- The nearest to 0.8% is 0.75% = 6/8%.
- The result will be 7.75%.
The margins remain fixed for the term of the loan
and are not impacted by the financial markets and movement of interest
rates. Lenders use a variety of margins depending upon the loan program
and adjustment periods. Most ARMs have an interest rate caps to protect
you from enormous increases in monthly payments. A lifetime cap limits
the interest rate increase over the life of the loan. A periodic or
adjustment cap limits how much your interest rate can rise at one
time.
Examples:
1. The initial interest rate is 4.5%, the index is 7%, and the margin is
3%, then the new interest rate = 7% + 3% = 10%. If the lifetime cap is
5% then the actual new interest rate will be 4.5% + 5% = 9.5%.
2. The initial interest rate is 6%, the index is 5%, and the margin is
3%, then the new interest rate = 5% + 3% = 8%. If the periodic cap is 1%
then the actual new interest rate will be 6% + 1% = 7%.
Your mortgage disclosure will tell you the exact index, to be used,
whether the weekly or monthly value applies, the lead time for your
index, the margin, and any caps.
Some types of ARMs offer payment caps, which limit the amount the
monthly payment can increase. If a loan has payment cap but has no
periodic interest rate cap, then the loan may become negatively
amortized: if the interest rate increases and the monthly mortgage
payment does not increase sufficiently then the payment does not cover
the interest payment, so the loan balance increases. However, you always
have the option to pay the minimum monthly payment, or the fully
amortized amount due.
With most ARMs, the interest rate can adjust once a year, every three
years, or every five years. The interest rate on negatively amortized
loans can adjust monthly. 1-year ARM means a loan with an adjustment
period of one year.
Some types of ARMs offer an initial lower interest rate than the fully
indexed rate (index plus margin) for the first six month, or the first
year. It is also known as teaser rate.
All ARMs are available with 30-year terms and some with 15-year terms.
Adjustable rate mortgages generally have a lower initial interest rate
than fixed rate loans. |