Adjustable Mortgage Rates the Risks Involved

An adjustable rate mortgage, or an ARM, is a type of mortgage loan where the interest rate on the note is adjusted on a periodic basis, based on an index. (In finance an index is a single number calculated from an array of different items, such as prices or quantity) This system works in the favor of the lender who is taking a risk by lending to the buyer, given the cost of funding. As the borrower pays off the note, the interest rate or even the term of loan may change over time. Adjustable rate mortgages are distinctive because of the index calculation and because there is usually a cap on charges. Depending on the country in which you live, an adjustable rate mortgage may be called a simply mortgage or exclusively identified. Because America has several types of mortgages it identifies this system as an ARM. For other countries however, this system may be the only option.

Understanding The Index Element Of Adjustable Rate Mortgages

All ARMs have an adjusting interest rate tied that is calculated by an index. The index is obviously not a globalized standard and is uniquely calculated for various part of the world. In Western Europe the “Tibor” index is used. In America, there are six common indices (plural of index) including the 11th District Cost of Funds Index, London Interbank Offered Rate, 12-month Treasury Average Index, Constant Maturity Treasury, National Average Contract Mortgage Rate and the Bank Bill Swap Rate. Banks may also publish what is known as a “prime lending rate” which would be used as the index.

How is the index applied? In one of three different ways. First, it could be applied directly, meaning that the interest rate will change precisely with the index. The interest rate will equal the index exactly, hence the term “direct”. A rate plus margin basis means that the interest rate will equal the underlying index and plus a margin. The margin is explicitly listed in the note and remains fixed for the entire life of the loan. You could think of margin as a gross profit the lender is making, though the precise definition is “the percentage difference between the index for a specific loan and the interest rate charged.” So you might see this listed as “LIBOR (the index of the London Interbank Offered Rate) plus 2% (the margin).” There is also a movement basis; in this system, the mortgage is fixed at an agreed upon rate and then adjusted based on the movement of the index. This is different from the other two systems because here the initial rate is not tied to the index, rather, the adjustments are tied to the index.

Adjustable Rate Mortgages Can You Afford The Risk?

Even in countries where consumers have a choice, many consumers choose ARMs over other types of mortgages. Why? For the most part, ARMs let borrowers lower their regular payments, since in exchange they are risking interest rate changes. Long or short terms may be affected by the size and capital of the financial lending institution. Generally, short-term borrowing is less expensive than long-term borrowing because of the risk factor. Caps are used as a protection to the borrower. If not for this limitation then payments would increase over time and became very difficult if not impossible for the borrower to pay. These limitations or caps may apply to: the frequency of the interest rate change, the periodic change in interest rate, or the total change in the interest rate over life.

Because of the nature of rising ARM rates, many consumers are stuck with a loan they cannot repay, and so some institutions may be accused of “predatory loans.” The main problem here is that consumers often do not understand the full nature of the adjustable rate mortgage. Before agreeing to an ARM, read detailed information on the term provided to you straight from the lender. Often times, these materials will have financial comparisons between types of mortgages. Ask questions and make sure that you understand not only how ARMs work in general but how the plan works for you, and if you can afford it in the long run.