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Chapter 9. Adjustable Rate Mortgages

┠What is an adjustable rate mortgage?

┠What is an index?

┠Which indexes are most often used?

┠How do I know which index is right for me?

┠What is a margin?

┠What is a start rate?

┠How can I best understand adjustable rate mortgages?

┠What is a flexible payment adjustable rate mortgage?

┠What is recasting and how will it affect my mortgage?

What is an adjustable rate mortgage?

The adjustable rate mortgage (ARM) is the favorite of most lenders. From the lender's point of view, it is the mortgage that is fair to all parties — it changes to reflect current market conditions. As interest rates rise and fall, the interest rate of your mortgage follows suit.

To understand ARMs, you must understand the language used with them. The interest rate of the loan is tied to an index.

What is an index?

An index is an interest rate that is publicly published, such as the interest paid on a government bill or note, the cost of funds for a Federal Reserve Bank district, the prime rate, and so on.

The interest rate on your loan may be higher than the index rate. For example, it could be 2% over the rate of the index used. You may have heard phrases such as 2% over prime, which means the lender is using the prime rate index and charging 2% more for the loan. The amount over the index rate is called the margin.

Your protection against skyrocketing interest rates is called a ceiling, or more commonly, a cap. For example, if your original interest rate is 5% and your cap is 5%, your rate can never go higher than 10%. You should also have a cap on an adjustment. This means that your rate cannot be raised by, for example, more than 1% per year (or whatever period is used for adjustments).

Which indexes are most often used?

One of the most important features of an adjustable rate mortgage is the index to which it is tied. If you plan to keep your loan for more than five years, it may be the most important feature, as all indexes do not react equally to rate changes.

There are two basic types of indexes. They are classified as leading and lagging. As the names imply, leading indexes react quickly to economic changes and are highly volatile. Lagging indexes adjust more slowly and do not reach the highs and lows of the leading indexes. Some of the indexes used to determine adjustable mortgage rates include the following.

• Constant Maturity Treasury (CMT)

• Treasury Bill (T-Bill)

• 12-Month Treasury Average (MTA)

• Cost of Deposit Index (CODI)

• 11th District Cost of Funds Index (COFI)

• Cost of Savings Index (COSI)

• London Interbank Offered Rate (LIBOR)

• Certificates of Deposit (CD) Indexes

• Prime Rate

To use an extreme historical example, in May 1981, the prime rate soared to 20.50%. The cost of funds index had also risen, but only to 11.43%. By May 1986, the prime rate had fallen to 8.25%, a 12.25% drop. The cost of funds index had also fallen, but only to 8.44%, a 2.99% drop. A mortgage lender's success is largely dependent on interest rate trends, especially if making portfolio loans. A lender selling loans to secondary lenders will not worry about rate changes five years from now. The lender making a portfolio loan will usually want to use a leading index. If rates rise, the increase is reflected quickly in the loan rate. If rates fall, it is less likely that the borrower will refinance and the lender will lose the loan entirely.

From the Expert

When interest rates are high, a leading index may be to the borrower's advantage. When rates are low, the lagging index is preferred.

How do I know which index is right for me?

Your decision depends primarily on the length of time that you intend to keep the loan. If you are planning to keep the loan for five years or less, you are probably better off getting the lowest interest rate available, even if it is tied to a leading index. Your protection is the cap on adjustments. The risk of the loan adjusting dramatically and unexpectedly in a five-year period is usually outweighed by the lower interest rate being offered. The longer you keep the loan, the greater the risk. This is especially true if the trend appears to be toward higher rates.

The advice is simple. If you plan to keep your loan for an indefinite period over five years and you believe interest rates will rise, get a fixed interest rate loan. If you only qualify for an adjustable rate loan, get one that uses a lagging index. The lagging index is most often the best for the borrower under any interest rate trend. If rates rise, they rise more slowly. If rates fall, you can refinance.

Something to remember when trying to estimate how long you will keep your mortgage: If your plan is to sell your property in a few years and buy a more expensive home, rising rates may prevent this by making the payments on the more expensive home beyond your reach. Also, refinancing may not be an option if rates rise, since you will have to pay the prevailing higher rate at the time you try to refinance. Planning to keep your mortgage for only a few years because that is how long you usually stay in one place before your job requires you to move is a much better reason. The following is a list of the most often used indexes and a short explanation of each. When you are offered an adjustable rate mortgage, ask your lender which index is being used and how it has reacted to economic changes over the last few years compared to other indexes. You can also do your own research by typing "mortgage indexes" into a search engine. There are several good websites that will list current index rates, as well as supply historical data.

Constant Maturity Treasury (CMT). These indexes are the weekly or monthly average yields on U.S. Treasury securities, and are based on closing market bids for actively traded Treasury securities. They are quick-reacting leading indexes. As of October 2007, the rate ranged from 4.11% on the one- year security to 4.24% on the five-year security. Checking the current rate may give you an indication of the direction in which rates are moving and the speed at which rates can change.

London Interbank Offered Rate (LIBOR). This index is based on the average interest rate of deposits of euros traded among banks in London. The LIBOR is also considered a leading index, adjusting quickly to world economic changes. As of April 2008, the LIBOR index was 2.72%.

• 11th District Cost of Funds Index (COFI). This index is based more on interest paid on savings and checking accounts. As you know, the interest paid by savings institutions on these accounts rises at a slower rate than loan rates. The 11th District encompasses the savings institutions (savings and loan associations and savings banks) headquartered in Arizona, California, and

Nevada. This rate is more commonly used in the Western states, but it is not confined to use there. It is a lagging index that moves at a much slower rate than either the CMT or LIBOR, and rarely reaches their extremes.

Prime Rate. The prime rate has historically been the rate banks charge their best customers for short-term loans. It is now also being used as a common index for equity lines of credit. Some lenders are offering rates below prime for equity lines with low loan-to-value ratios for customers with high credit scores. The prime rate will move on Federal Reserve Board interest rate hikes, and generally reflects the Fed's view of the strength of the economy and the threat of inflation. In times of high inflation, the prime rate can rise quickly.

There are several other indexes that are not as commonly used. If you are getting an adjustable rate mortgage loan, be sure to question the lender about the index being used and its volatility.

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