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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 the one-year Treasury Bill |
| |
| 2. |
11th District Cost
of Funds Index (COFI) |
| |
| 3. |
London Interbank Offered
Rate (LIBOR) |
| |
|
| |
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Chapter 2: How mortgages work
