mortgage

How Libor impacts your ARM

When shopping for an adjustable-rate mortgage, you'll hear all kinds of acronyms tossed around. A key one to keep in mind is Libor, or London Interbank Offered Rate.

It's natural to wonder why something in London could impact a mortgage if you're looking to buy a home in Philadelphia or Phoenix. But Libor -- which is an interest rate banks charge each other to borrow funds -- is a common benchmark for establishing short-term interest rates.

You'll encounter Libor and other indexes, such as COFI (11th District Cost of Funds Index) when you're looking for an adjustable-rate mortgage. ARMs typically are tied to one of these indexes, plus a certain number of percentage points, which is called a margin.

Libor is set each day by the British Bankers' Association. You can track Libor and find the current rate on Bankrate.com.

How does it work?

Libor helps determine a homeowner's monthly mortgage payment. For example, with a one-year ARM, the interest rate for the first year of the loan is usually far lower than on a fixed-rate loan. After one year, the mortgage rate adjusts periodically based on an index like Libor or COFI.

In most cases, the mortgage comes with caps that limit how much the payments can increase when the loan resets, such as 2.25 percent plus the one-year Libor index.

ARMs can be good when interest rates are falling, as your monthly payment will shrink. On the flip side, if interest rates rise, you'll pay more.

Adjustable-rate mortgages tied to Libor or other indexes may be a good choice for borrowers who don't plan to stay in their house very long and want to have lower initial mortgage costs.

ARMs also can work for consumers with an income cushion who can cover higher monthly payments should interest rates rise.

Bankrate can help you decide what type of mortgage is best for you.

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