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What Defines An Adjustable Mortgage Rate Staff - Mortgage Lenders Plus.com

Until a person goes shopping for a home loan, the most he or she usually knows about the business is that there are fixed rate loans and there are adjustable rate mortgage loans (ARMs) that typically start out with a low interest rate which at some point, goes up.

The fact is that most ARMs adjust many times. When the product was first introduced, the adjustable rate mortgage definition was a loan that adjusted every twelve months. Now, there are loans available with three year (3/1), five year 5/1), seven year (7/1), even ten year (10/1) grace periods before they “adjust.” When the adjustment occurs, it is repeated on an annual basis.

Any adjustable rate mortgage definition will refer to an “index” and a “margin.” The interest rate on an ARM is established based on an index, which is usually a figure arrived at based on one or more monetary market statistics. Added to that index is the margin, a number of percentage points agreed upon in the mortgage. The margin can add two or three percentage points to the interest rate.

The index can be a figure derived from a number of sources. Popular index sources include the London Interbank Offering Rate (LIBOR), the 11th District Cost of Funds (COFI) and the 12 Month Treasury Average (MTA). Two of these sources, the COFI and the MTA, are averages. The index for your adjustable rate mortgage loan based on MTA would be the average Treasury rate over twelve months. A COFI index would also be an average of several COFI rates over a period of months.

The LIBOR index is an example of a “spot” index, as opposed to an average index. When you’re looking at the adjustable rate mortgage definition for a proposed loan, give this terminology careful consideration. Your ARM index will be whatever the LIBOR rate is on the day your mortgage rate is due to change. By contrast, an average index would reflect the average rate for a money market rate – in the case of MTA, an average over a year.

Because averages tend to reflect more general trends and slower rates of movement, they are considered to be more stable figures. A spot rate, on the other hand, has the risk of spiking the one month when it’s time for your adjustable rate mortgage loan to readjust.

For that reason, the margins on average-based adjustable rate mortgage loans tend to be a little higher. Spot-based ARMs will have a somewhat lower margin and expose the borrower of a sudden jump in his ARM index – and therefore, a severe hike in the mortgage payment for at least one year.

Some ARMs include interest rate caps in their adjustable mortgage rate definition, which provide a little protection. Some ARMs provide for upward adjustment, but do not provide for a reduction in payment should the index fall. These are the details that make the difference between a reasonable ARM and a bad loan. It’s critical also to study the performance of the index that you are considering. Look at its volatility and what economic factors trigger a change in its rates. Some are domestic in nature while others – like LIBOR – more oriented to global economic factors.