An Adjustable Rate Mortgage, more commonly known by its acronym ARM, is a mortgage loan characterized by the ability of the loans interest payments to be changed due to market and index changes. Adjustable Rate Mortgages are also commonly called variable rate mortgages, or tracker mortgages.
What is an Adjustable Rate Mortgage?
In the standard definition of an Adjustable Rate Mortgage, it is a loan offered by a lender which has an interest rate which fluctuates according to whatever market is tied to the principal. The loan may even be offered at the lenders base rate and be changed to correspond with the market format at a later time.
What Is An Index And How Does It Apply to Adjustable Rate Mortgages?
An index is a catalog of interest expenses which are incurred by lending companies or institutions. Several can be used and is often up to the discretion of the lender. For instance there is:
- the London Interbank Offered Rate, also known as LIBOR
- the Cost of Funds Index, also known as COFI
- the Monthly Treasury Average Index, also known as MTA
- the Bank Bill Swap Rate, also known as BBSW
- the Constant Maturity Treasury, also known as the CMT
These are just a few examples of the different indexes that can be used to determine the interest rate on a Adjustable Rate Mortgage. It should be noted however that some lenders may not use a standard index like the ones listed above, and instead will use their own cost of funds index. After a lender chooses which index to base the Adjustable Rate on there are actually a few ways the index can be applied, those include;
- Directly applying the index to the interest rate, this enables the interest rate to change exactly with the fluctuations, if any.
- Allowing the rate of interest to be placed on a rate plus margin basis. this allows the interest to continue to fluctuate but with a set range such as CMT +3% would translate to 3% being the margin, and CMT being the index
- Another way is to apply the index to a movement basis, this allows the mortgage to originate at a mutually agreed upon level then be adjusted based on the trends within the particular index they are tied too.
What are Caps, And How Do They Effect an Adjustable Rate Mortgage?
In the constantly fluctuating market a steady increase may begin to strain the borrower to the point of financial hardship, which is why caps were put into place to stop constantly rising interest rates from strangling otherwise blemish free borrowers. These may be deployed in a variety of different ways, including; to the frequency of the interest rate changes, the total change in interest rate changes, or even to the periodic changes in the interest rate. Caps can also be split up into three sub categories each protecting the borrower at a certain stage in the loans life. These categories are known as initial adjustment caps, subsequent adjustment caps, and life caps.