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Most adjustable rate loans (ARMs) have a low introductory rate or
start rate, some times as much as 5.0% below the current market rate of a fixed
loan. This start rate is usually good from 1 month to as long as 10 years. As a
rule the lower the start rate the shorter the time before the loan makes its
first adjustment.
Index
- The index of an ARM is the financial instrument that the loan is
"tied" to, or adjusted to. The most common indices, or, indexes are
the 1-Year Treasury Security, LIBOR (London Interbank Offered Rate), Prime,
6-Month Certificate of Deposit (CD) and the 11th District Cost of Funds (COFI).
Each of these indices move up or down based on conditions of the financial
markets.
Margin
- The margin is one of the most important aspects of ARMs because it is added to
the index to determine the interest rate that you pay. The margin added to the
index is known as the fully indexed rate. As an example if the current index
value is 5.50% and your loan has a margin of 2.5%, your fully indexed rate is
8.00%. Margins on loans range from 1.75% to 3.5% depending on the index and the
amount financed in relation to the property value.
Interim
Caps - All
adjustable rate loans carry interim caps. Many ARMs have interest rate caps of
six-months or a year. There are loans that have interest rate caps of three
years. Interest rate caps are beneficial in rising interest rate markets, but
can also keep your interest rate higher than the fully indexed rate if rates are
falling rapidly.
Payment
Caps - Some
loans have payment caps instead of interest rate caps. These loans reduce
payment shock in a rising interest rate market, but can also lead to deferred
interest or "negative amortization". These loans generally cap your
annual payment increases to 7.5% of the previous payment.
Lifetime
Caps - Almost
all ARMs have a maximum interest rate or lifetime interest rate cap. The
lifetime cap varies from company to company and loan to loan. Loans with low
lifetime caps usually have higher margins, and the reverse is also true. Those
loans that carry low margins often have higher lifetime caps.
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