How the Interest Rate on an ARM Is Determined
ARM interest rate is the interest rate of the Adjusted Rate Mortgage. Adjusted Rate Mortgages have variable interest rates - interest rates that change on monthly basis depending on market conditions. The market conditions affect a number of financial factors, which, in turn, cause the interest rates to rise and fall. Markets are, by nature, volatile and not always easy to predict, but you will have a better shot of predicting which way the adjustable mortgage rates will go if you pay attention to the following.
Index, or reference rate, is a average interest rate at which certain financial institutions borrow unsecured funds. The index is a primary factor behind the changes in interest rates. Different adjustable rate mortgages use different indexes. In United States, it is usually one of the following indexes:
- 11th District Cost of Funds Index (COFI) - this index is based on the interest expenses reported by qualified member banks of the Federal Home Loan Bank of San Francisco. This index is updated once a month. London Interbank Offered Rate (LIBOR) - this index indicates the interest rates at which London-based banks borrow funds. This index is updated daily. This index is most commonly used by private mortgage lenders. 12-month Treasury Average Index (MTA) - this index is based on the 12-month average of the monthly yields of the securities issued by the US Treasury. Because of this, it is more stable than some of the other indexes. It is calculatedonce per month. Constant Maturity Treasury (CMT) - this index is calculated using the yield curve that's based on the sales of securities issued by the US Treasury. The yield curve is the mathematical relationship between the interest rate and the maturity date of the securities. CMT tends to be more volatile than many other indexes. It is
primarely used by government-backed mortgages, such as the ones issued by the Federal Housing Authority and Department of Veterans Affairs.
National Average Contract Mortgage Rate - this index is based on the interest rates home buyers paid if they bought homes within five working days of the end of the month. It is the traditional index for adjustable rate mortgages.
While index play an important role in the way ARM interest rates are adjusted, most lenders realize that the dramatic shift in rates can put you in financial hardship. This is why they created index caps - the maximum limit on how much the rates can rise. They are divided into two types - periodic caps and lifetime caps. The periodic caps limit how much the interest rates can change during a certain period (usually either a month or a year), which lifetime caps limit how much the interest rates can change during the entire life of the loan. Many ARMs will have more than one periodic index cap .
It is worth noting that while index caps put limits on interest payments, they don't actually make the extra money disappear. Rather, the money that's above the cap is redistributed towards the loan balance, which can lead to the increase in monthly payments.
This is a fixed number determined at the beginning of the loan. That means that, unlike other factors, it is not adjusted during the life of the loan, giving the interest rates some small measure of consistency.
Finally, many ARM lenders will include interest rate discounts with their ARMs. Those discounts usually expire within 1-2 years of the life of the loan, but while they are in place, they will make interest payments lower than what they would otherwise be.Source: m.mortgage101.com