Adjustable Rate Mortgages
Adjustable Rate Mortgages (ARM's), or sometimes called Variable Mortgages, are mortgage loans where the interest rate fluctuates according to a particular index. The index used will be agreed upon during the loan application process. Some well-known indexes used with ARM' s include: the CODI (Cost of Deposits Index), the COFI (Cost of Funds Index), and the LIBOR (London Inter Bank Offering Rate).
With a CODI-indexed loan, the interest rate would not fluctuate as wildly as some of the others because the index is based on an annual average. The COFI, on the other hand, represents the financial intuitions of the Southwest in states such as California, Arizona, and Nevada, specializing in savings and loan. This index is largely based upon savings accounts and so can be slow to react to the wild swings of the market. This is great for the borrower when the rates are climbing, but not so great when they are falling. The index is mostly used on very short term loans such as a one or six month ARM.
The LIBOR is an international index that represents the average interest rate on deposits traded between London Banks (now the Eurodollar). It is more reactive than the COFI and has several different versions, one being posted daily by the British Banker ’ s Association (BBA).
Your interest rate is calculated by combining the index with a 'margin,' a set percentage that the lender adds; usually 2-3%, which stays the same throughout the term. And though your rate is tied to the index rate and can rise and fall accordingly, that doesn't mean it can skyrocket out of control. Most ARM's have caps, which are limits for how fast and high interest rates can rise.
Your mortgage loan might have a periodic cap of one percent, and a lifetime cap of five percent. Your periodic cap will be in place to make sure the rates do not rise over 1% at any given time, and your lifetime cap will guarantee that it will not rise over 5% for the duration of the loan term.
Types of ARM's:
A convertible ARM is a program equipped with an option to convert it to a fixed rate mortgage within a certain proscribed amount of time. This can be useful if rates jump, but you might end up locking in a higher rate than the current market rate. It works in reverse as well, allowing an FRM to be converted if the market rate falls below your rate. Though generally, convertible mortgages will have higher interest rates and points.
Two-step mortgages have a fixed rate for a certain beginning period of time (usually 5-7 years) and then change to an adjustable rate. These are the hybrids borrowers are usually warned against, as they are called "teasers" by those familiar with the industry.