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Posted by Kelly Chung on January 7, 2009

Adjustable Rate Mortgage (ARM) is a variable rate loan.  ARMs usually offer a lower initial rate than fixed-rate loans.  The interest rate can change at specified time periods based on changes in an interest rate index that based on current finance conditions, i.e. LIBOR index or the Treasure index. Common indices include the cost of funds for savings and loan institutions, the national average mortgage rate, and the most popular one-year rate for the government’s sale of treasury bills. The ARM promissory note states maximum and minimum rates.  When the interest rate on an ARM increases, the monthly payments will increase.  When the interest rate on an ARM decreases, the monthly payments will be lower.

For an ARM, the lender designates an index and then add a margin above this index. For examle, the T-bill (Treasury bill) index were 7 and the lender’s margin were 2.5 (= 250 basis points), the ARM would call for an interest rate of 9.5. A big problem in an ARM is the possibility of negative amortization.  When the index rises while the payment is fixed, it may cause the payments to fall below the amount necessary to pay the interest required by the index. The shortfall is added back into the principal, causing the principal to grow larger after the payment.
As of  Feb 3 2000, the ARM Indexes: Prime rate was 8.75%
As of Jan 22 2008, the ARM Indexes: Prime rate was 6.5%
As of Dec 16 2008, the ARM Indexes: Prime rate was 3.25%

Before choosing an ARM over a fixed-rate mortgage, compare the current index value plus margin (i.e. 3.54% one-year Treasury Index + 2.75% margin = 6.21%) to the current fixed-rate (8.25%).  The difference (2.04%) is the interest rate savings that you would get by choosing an ARM if interest rates were to remain the same.


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