Adjustable Rate Mortgage (ARM)
The term ARM stands for "Adjustable Rate Mortgage." Typically, the interest rate is fixed for a short period of time, and then becomes adjustable. Most common fixed period ARM's are for 3, 5, 7 and 10yrs. Generally, the shorter the fixed period, the lower the interest rate. The adjustment is based upon a specific Index that the ARM is tied. There are two main indexes that ARM's are tied to, the LIBOR index and Treasury index. These adjust slightly almost daily, and as they go up and down, your interest rate can go up and down after the fixed period has elapsed. The adjustment typically takes place one time per year each year after the fixed rate ends and sometimes every 6 months. The rate is determined by the index the ARM is tied to, plus a set Margin. A typical Margin is anywhere from 2.250 - 2.750. For example, if your rate is set to adjust this month and you have a LIBOR ARM, your new rate for the year would be the Margin (Let's say 2.500) + 1yr Libor Index today of 2.34 = 4.840% interest rate. Now this is an attractive interest rate, however, when the 1yr Libor is at 5.42, as it was in July 2007, your new rate this year would be 2.500 + 5.420 = 7.920%. Pretty big swing isn't it? For this reason, if you decide to choose an ARM, always assume that you will either have refinanced or will have sold your home prior to the fixed period elapsing.
Common Fixed Period ARM Index Descriptions: (per Moneycafe.com)
LIBOR "London Inter-Bank Offered Rate"
-It is based on rates that contributor banks in London offer each other for inter-bank deposits. These rate calculations are complex as they incorporate many variables, such as time, maturity, and currency rates.
1yr Constant Maturity Treasury Rate (CMT)
-This index is an average yield on United States Treasury Securities adjusted to a constant maturity of 1 year, as made available by the Federal Reserve Board. Yields are interpolated by the United States Treasury from the daily yield curve. This curve, which relates the yield on a security to it's time to maturity, is based on the closing market bid yields on actively traded Treasury securities in the over-the-counter market. This rate is updated after the Federal Reserve releases its date in its monthly meeting.
Negative Amortization ARM's
This type of ARM is commonly referred to as an "Option ARM," or "Pick-A-Pay," These were the hot product from 2003 - 2006 because the index's they were tied to were so low and they offered a very low minimum payment. These ARM's adjust monthly dependent on the index that they are tied, transversely so does your monthly mortgage statement. You more than likely received quite a few mailers on this product whether you knew it or not. Lenders often advertise a 1.000-2.000% interest rate, but that is only half of the truth. What they didn't tell you was that this was a negative amortization loan and that by making the 1.000% payment, you were deferring the interest you were supposed to be paying that payment to your loan balance. Now, if you did not want to make the minimum payment due, you had your option to pick an alternative interest only payment, 30yr fixed P/I payment or 15yr Fixed P/I payment. But who would do that when they can pay such a low payment, right? Some people do not mind their loan balance going up because they figure their home is appreciating just as fast of not faster, so they'll never have to worry. Now that the real estate market has tumbled, these same people are not so happy anymore and can even owe more than their home is worth; which is why these ARM's are beginning to be referred to as "Exploding ARM's"
In summary, this type of financing is very aggressive and is only suitable for certain borrowers. If you understand how this product works and do not mind the risk it may suit your objectives. However, nine times out of ten there is a better way to structure your loan.
Common Negative Amortization ARM Index Descriptions: (per Moneycafe.com)
12 month Treasury Average (MTA)
-This index is the 12-month of the monthly average yields of US Treasury Securities adjusted to a constant maturity of 1-year. What this mean is, this index is calculated by averaging the previous 12 rates of the 1yr CMT (described above). Because this index is an average, it is more stable than the 1yr Treasury index.
11th District Cost of Funds Index (COFI)
-The 11th District Cost of Funds Index is the weighted average of the cost of borrowings (funds) to member banking institutions of the Federal Home Loan Bank of San Francisco (the 11th District). The index rate tends to lag market interest rate adjustments and is relatively stable because institutions borrow money for varying terms and do not pay market rates for all of their funds. For example, institutions most commonly borrow from depositors in the form of certificates of deposit (cd's). The terms on cd's vary from several days to several years and the interest rates paid were determined at the time of the deposit.
Wachovia Cost of Savings Index (formerly World Savings COSI)
-The World Savings COSI was discontinued in June 2007 and replaced by the Wachovia Cost of Savings Index. Rates published prior to July 2007 are the World Savings/Golden West COSI. Rates thereafter reflect the new Wachovia COSI.)This index is based on the weighted average of all the interest rates paid on certificates of deposit held by Wachovia's individual depositors as of the last business day of each month. This index is specific to the Wachovia banking institution. This index is reflective of the rate Wachovia is paying to individuals for their deposits.