About one in five mortgage applicants
nowadays gets an adjustable-rate mortgage, or ARM. The hardest-to-understand
element of an ARM is the index.
When you get an ARM, two main factors determine the
rate you pay: the index and the margin. The index is a rate set
by market forces and published by a neutral third party. The margin
is an agreed-upon number of percentage points that is added to the
index to determine your rate.
A thorough mortgage shopper will run across a bunch
of acronyms to denote various ARM indexes, such as COFI, LIBOR,
MAT and CMT. Each index responds at its own peculiar pace to the
economy's ups and downs.
Indexes can be divided into two broad categories:
those based upon rate averages and those based upon more volatile
spot rates. There is some overlap between the two categories. ARMs
indexed to average rates tend to move more slowly, in rather gradual
steps, whether the markets are rising or falling. ARMs based on
spot rates go up and down abruptly.
Larry Goldstone, president of Thornburg Mortgage, a portfolio
lender that focuses principally on ARMs, says
ARMs based on averages tend to have higher margins
than ARMs based on spot rates.
Someone who gets an ARM indexed to rate averages
"gets one benefit and one drawback," Goldstone says. "The
benefit is that, in a changing rate environment, an average index
will move more slowly, so the payment changes more slowly. The drawback
is that the margin typically is higher, and so the rate you pay
is higher."
Indexes based on average rates
include the 11th
District Cost of Funds Index, or COFI, and the
12-month moving Treasury average, (variously
called the MTA and the MAT, for monthly average
Treasury).
Of indexes based on spot rates, among the most popular
is the one-month
London Interbank Offered Rate, for London Interbank Offered Rate. Then there is the
constant maturity Treasury, or CMT, index, which comes from a short-term
average that acts more like a spot rate. Other spot indexes are
based on the prime rate and yields on certificates of deposit.
One way to compare ARMs with different index options is to look at their fluctuations in a graph. That will help you understand how rapidly and how much the rates change.
Here is a rundown of some of the popular types of
adjustable-rate mortgages, how they work and who they are suited
for:
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| Popular types of adjustable-rate mortgages: |
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11th
District Cost of Funds Index, or COFI,
index: Rates on COFI-indexed mortgages
move up and down slowly. With most COFI-based
loans, the rate is adjusted every month and the
monthly payment is adjusted once a year. This
means that some borrowers can end up owing more
than they borrowed if their payments don't cover
all the interest due, a phenomenon called "negative
amortization."
COFI-based loans are indexed to the cost of funds
for the 11th district of the Federal Home Loan Bank system. The
11th district consists of banks based in Arizona, California and
Nevada. The cost of funds index is a weighted average of the interest
that member banks pay on money they borrow, mostly on customers'
checking and savings accounts.
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