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There are several aspects of
ARMs that impact interest rates including
the index, margin, interim caps, and
payment caps. The index of an ARM is
the financial instrument that the loan
is linked to and indexes move up and
down with the market. The margin is
added to the index to determine the
interest that the borrower will pay.
Caps, such as the interim cap, protect
borrowers against rising interest rates.
Payment caps, on the other hand, place
a maximum on the amount a borrower must
pay. This type of cap also protects
against payment shock associated with
rising interest rates
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. |
