Adjustable rate mortgages (ARMs) come in an infinite variety. The primary advantage to an adjustable rate mortgage is the lower initial interest rate (usually 2–3% lower than fixed rate mortgages) at the beginning of the mortgage. However, as the name says, this loan is adjustable and after a specified time the interest rates and payments will probably increase. ARMs calculate the interest rate based on an interest rate index such as the U.S. Treasury Bill Rate.
Because this type of loan offers lower initial interest rates, borrowers can qualify for a larger loan amount. The ARM is a good choice for people who know they will not stay in the home for a long time and for those who are sure that they can financially handle a much larger payment. ARMs usually have a rate cap that limits how much the rate can change and the number of changes allowed over a specific period of time. In an ARM the borrower is betting his or her home that the specific economic interest rate index will not rise more than the borrower can pay. In today’s economic and job climate this may be a very risky bet.
The top three interest rate indexes that are used by adjustable rate mortgages are:
• U.S. Treasury Bill Rate. The weekly constant maturity yield on the one-year treasury bill. The yield that debt securities that
are issued by the U.S. Treasury are paying, as stated by the
Federal Reserve Board.
• COFI. 11th District Cost of Funds Index, which is the interest that financial institutions in the United States are paying on deposits that they hold.
• LIBOR. The London Interbank Offered Rate, or the rate that most international banks are charging each other on large loans.
Adjustable rate mortgages come in a variety of actual loans. The most common are the interest only mortgage; 100% mortgage; convertible mortgage, which starts as an ARM with an option to convert to a fixed rate mortgage after a period of time; and, the balloon mortgage.