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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:
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| Major indexes |
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| 1. |
Weekly constant
maturity yield on one-year Treasury Bill |
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The yield debt securities
issued by the U.S. Treasury are paying, as tracked by
the Federal Reserve Board. |
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| 2. |
11th District Cost
of Funds Index (COFI) |
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The interest financial institutions
in the western U.S. are paying on deposits they hold. |
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| 3. |
London Interbank Offered
Rate (LIBOR) |
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The rate most international
banks are charging each other on large loans. |
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Interest-only ARMs
Around the turn of the 21st century, lenders
began to market interest-only mortgages to middle-class borrowers.
Formerly the preserve of what lenders called "affluent clients,"
interest-only mortgages are usually adjustables. The borrower is
required to pay only the interest for a specified period, often
10 years. After that, it adjusts to the going interest rate, as
tracked by a specified index. After that, the loan amortizes at
an accelerated rate. During the interest-only period, the borrower
can choose to pay some principal, too. By providing flexibility
in the size of monthly payments, interest-only mortgages often are
a good match for people with fluctuating monthly incomes: salespeople
who are paid by commission, for example.
Variety of flavors
Some ARMs come with a conversion feature that
allows borrowers to convert their loans to fixed-rate mortgages
for a fee. Others allow borrowers to make interest-only payments
for a portion of their loan terms to keep their payments low. But
no matter the exact terms, most ARMs are more difficult to understand
than fixed-rate loans.
To keep your financial options open, make sure to
ask the mortgage lender if the ARM is convertible to a fixed-rate
mortgage. Also, ask if the ARM is assumable, which means when you
sell your home the buyer may qualify to assume your existing mortgage.
That could be desirable if mortgage interest rates are high.
Bankrate.com also surveys ARM
interest rates.
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