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A call to ARMs

Dr. Don Taylor Dear Dr. Don,
What would you suggest to be the most stable ARM index? I've heard conflicting reports from LIBORs to COSI and the list goes on. With interest rates creeping back up, ARMS are looking very attractive. How can we minimize the risk by choosing the most stable one?
-- Nelson Niche

Dear Nelson,
With interest rates creeping back up you need to be wary of using adjustable-rate financing when buying or refinancing a home. Adjustable-rate mortgages are best in an interest rate environment where rates are stable or heading lower. Short-term rates have already started to head higher with the Federal Reserve increasing the targeted fed funds rate twice already this summer. The bonus has been that the Fed's action has reduced investors' expectations for future inflation and given homeowners another shot at low fixed-rate mortgages.

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A hybrid mortgage like a 5/1 ARM where the interest rate is fixed for the first five years and then resets annually can be a good compromise because it has a lower interest rate than a 15-year or 30-year fixed rate mortgage.

Bankrate's Mortgage Adviser, an interactive worksheet, can help you decide. Take the "Fixed or Adjustable Rate Mortgage - Which is right for you?" worksheet for a spin and see if you agree with its recommendation.

Still convinced that an ARM is the way to go? Then your search for a stable index is the right decision. Indexes that move in tandem with changes made by central banks are more volatile than indexes that are moving averages of past rates, or indexes that lag changes in interest rates. The table below discusses the major indexes used in pricing ARMs. Use Bankrate's Rate Watch feature to follow these rates.


COFI - Cost of Funds Index

A yield index based upon the cost of funds to savings & loan institutions in the San Francisco Federal Home Loan Bank District.

Tends to lag changes in market interest rates.

COSI - Cost of Savings Index

COSI is not based on actual interest paid on deposit accounts, but on a weighted annualized rate of all interest rates in effect for deposit accounts as of the last day of each month for deposits held by World Savings.

Since it is based on the interest rates paid on deposits and those rates tend to be "sticky," this index is very stable.

MTA - 12-Month Treasury Average

A moving average using the previous 12 monthly observations of one-year constant maturity treasury (CMT).

As a moving average going back over the past year, it is more stable than an index base solely on current values.

PRIME - Prime Rate

The interest rate a bank charges its best or "prime" customers. Each bank will quote a prime lending rate. Many institutions quote prime rates established by large money center commercial banks. There is also a prime rate average listed in the Wall Street Journal that is an average of the largest commercial banks.

The prime rate tends to move in lockstep with changes in the targeted fed funds rate.

LIBOR -- London Interbank Offer Rate

It's the rate of interest at which banks offer to lend money to one another in the wholesale money markets in London.

LIBOR is influenced by changes in both the Bank of England's official rate and the targeted fed funds rate.

Although I don't think ARMs are the right choice in this interest rate environment, you can find an ARM that will lag the market if rates start to head higher.

-- Posted: September 7, 2004



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