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Dr. Don Taylor, CFA, Bankrate.com advice columnistUnderstanding a LIBOR ARM

Dear Dr. Don,
What is a 5/1 LIBOR ARM?
-- Silviu Selects

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Dear Silviu,
An adjustable-rate mortgage, or ARM, has a variable interest rate. The interest rate on a LIBOR ARM varies with changes in the London Inter-Bank Offered Rate, or LIBOR. Think of LIBOR as the British equivalent of the fed funds rate.

There are different LIBOR rates, so you need to know which LIBOR rate the mortgage is priced on. Bankrate tracks the one-, three-, six- and 12-month LIBOR rates on its Rate Watch pages.

A 5/1 ARM is a hybrid ARM, meaning it has both a fixed-rate and variable-rate component. In the first five years of the mortgage, the loan has a fixed interest rate. After five years, the interest rate is reset at the pricing spread stipulated in the loan agreement. Adjustable-rate mortgages can have rate caps and floors that limit how the rate adjusts, either for a single change or in aggregate over the term of the mortgage. It's important to know how the interest rate on a mortgage loan can change based on the terms of the loan agreement.

A 5/1 ARM gives you the certainty of a known interest rate in the early years of the loan and normally carries a lower interest rate than a 30-year fixed-rate mortgage because the borrower is taking on interest rate risk after the first five years of the loan.

As I write this, the Bankrate national average interest rate on a 30-year, fixed-rate mortgage is 6.42 percent, while the national average on a 5/1 ARM is 6.24 percent. If you only plan on being in the house for about five years, using 5/1 ARM financing gives you a lower interest rate with very little interest rate risk.

ARMs, even 5/1 ARMs, can be priced on a host of different underlying interest rates. LIBOR is just one. Others include the cost of funds index, or COFI; the cost of savings index, or COSI; the Treasury bill rate; the constant maturity treasury, or CMT; the monthly treasury average, or MTA, and the prime rate.

Bankrate has an interactive work sheet that can help you decide if a hybrid ARM is right for you. It won't advise you on which underlying index best fits your needs, but you'll see if a 5/1 ARM is suggested as a preferred choice in financing your home.

To ask a question of Dr. Don, go to the "Ask the Experts" page and select one of these topics: "financing a home," "saving & investing" or "money."

Bankrate.com's corrections policy -- Posted: Oct. 23, 2006
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