In addition to the many decisions you have to make when you are choosing a home loan, such as whether to go fixed or floating rate, how much down payment to make and how many points to pay, lenders have further complicated everything by offering a wide range of choice of indexes for ARMs (adjustable rate mortgages).
When we speak of the “index”, we are speaking of the base financial instrument that the adjusting rates will be based upon. Various indices are used, including government treasury instruments, the Fed Fund rate or LIBOR.
The rate on an ARM is adjusted periodically upwards, or downwards, based upon the movement in the general interest rate environment, but tied to a specific instrument. One such instrument would be Certificates of Deposit-your mortgage rate would go up and down with the CD rate. ARMs have rate adjustment caps, which means that the rate on your mortgage will only go up at certain intervals (every three or six months, for example), so that if the CD rate goes up, you may not have an increased rate for a few months, if your rate just adjusted recently. By the same token, if your adjustment is scheduled to take place immediately after the CD rate increased, you will have that rate for a while, even if the CD rate is lowered in the meantime.
There are any number of ARM indices, and they include the CDs, LIBOR and government bonds mentioned. The Fed Funds rate is the most popular index for ARMs. LIBOR, the London Interbank Offered Rate, is another popular index, and is the rate used by international companies to borrow.
Deciding upon which index is the one for you will depend on your own situation as well as your view of interest rate movements. CD ARMs adjust every six months, for example, and therefore react more quickly to interest rate changes. ARMs that have the Tbill interest as the index do not move as frequently as the CD index. LIBOR is the index that moves the most frequently and the most rapidly, so if you want to take frequent advantage of the downward level of lowering rates, this is the index for you.
But in addition to these standards, new products are always been put on the mortgage market; an example would be the option ARM, which lets a borrower decide how much mortgage he is going to pay each month! There is a minimum payment that allows for the interest (so the bank gets its money) and then the other options will pay down some portion of equity. Be warned that minimum payment option can result in an increasing, rather than decreasing mortgage, a phenomenon known as negative amortization.
This is a lot of information for the borrower to digest, and the best solution is to talk to a professional mortgage broker who can explain it all and recommend the best course for you.
