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