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  Mortgage Basics   Chapter 2: How mortgages work
You can get a mortgage in many places, but they all share the same characteristics. We explain.
 
   

Adjustable-rate mortgages

 

Adjustable-rate mortgages, or ARMs, differ from fixed-rate mortgages in that the interest rate and monthly payment move up and down as market interest rates fluctuate.

Most have an initial fixed-rate period during which the borrower's rate doesn't change, followed by a much longer period during which the rate changes at preset intervals.

Adjustable rates start low
Rates charged during the initial periods are generally lower than those on comparable fixed-rate mortgages. After all, lenders have to offer something to make it worth their while to assume the risk of higher rates in the future.

The initial fixed-rate period can be as short as a month or as long as 10 years. One-year ARMs, which have their first adjustment after one year, used to be the most popular adjustable, and were the benchmark. Recently the standard has become the 5/1 ARM, which has an initial fixed-rate period that lasts five years; the rate is adjusted annually thereafter. That type of mortgage, which mixes a lengthy fixed period with an even lengthier adjustable period, is known as a hybrid. Other popular hybrid ARMs are the 3/1, the 7/1 and the 10/1.

These hybrid ARMs -- sometimes referred to as 3/1, 5/1, 7/1 or 10/1 loans -- have fixed rates for the first three, five, seven or 10 years, followed by rates that adjust annually thereafter.

After the fixed-rate honeymoon, an ARM's rate fluctuates at the same rate as an index spelled out in closing documents. The lender finds out what the index value is, adds a margin to that figure and recalculates the borrower's new rate and payment. The process repeats each time an adjustment date rolls around.

Major Indexes
Most ARM rates are tied to the performance of one of three major indexes:

Major indexes
Most ARM rates are tied to the performance of one of three major indexes:
1. Weekly constant maturity yield on the one-year Treasury Bill
 
2. 11th District Cost of Funds Index (COFI)
 
3. London Interbank Offered Rate (LIBOR)
 
 
-- Posted: May 1, 2006
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Mortgages
Compare today's rates
NATIONAL OVERNIGHT AVERAGES
30 yr fixed mtg 4.23%
15 yr fixed mtg 3.23%
5/1 ARM 3.45%
Rates may include points
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