ARM Loan

By: EconomyWatch Content   Date: 14 December 2009

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The interest rate on an Adjustable Rate Mortgage or ARM loan is periodically adjusted based on a variety of indices. In these types of loans, the payments are made by the   borrowers but it changes after a pre-specified time along with a change in the interest rate. The adjustable rates on ARM loan help to transfer a part of the interest rate risk from the lender to the borrower. These are generally used when the interest rate movement is unpredictable.

 

Adjustable Rate Mortgage Loans and the Indices

The interest rate on an ARM loan is tied to different types of indices in various regions across the world.

 

In Europe, the ECB refinance rate or the EURO Interbank offered rate is used for ARM loans.

 

Some of the commonly used indices in the US are:

ü      Cost of Funds Index (COFI)

ü      London Interbank Offered Rate (LIBOR)

ü      12-month Treasury Average Index (MTA)

ü      Constant Maturity Treasury (CMT)

ü      National Average Contract Mortgage Rate

ü      Bank Bill Swap Rate (BBSW)

 

In other countries, the central bank’s prime lending rate may be used as an index for an adjustable rate mortgage loan

 

 

Linkage between ARM Interest and Index

 

An index can be tied to an ARM loan in three ways:

 

ü      A direct application: The interest rate on the ARM loan changes directly with the index or the interest rate is directly equal to the interest.

ü      On a rate plus margin basis: The interest rate will equal the index plus a pre-specified margin mentioned on the loan note. The margin remains fixed over the life time of the loan.

ü      Movement Basis: The mortgage loan is originated on a fixed rate and then adjusted based on the movement in an index. However, it is not the interest rate but the adjustments to the rate that are tied to an index.

 

 

Features of an ARM Loan

The ARM loan’s features are:

ü      Initial interest rate is significantly below the market rates.

ü      It is riskier than a fixed rate mortgage.

ü      The adjustment is fairly determined since the indexes are not changed by the lender.

 

Remember, the banks and financial institutions issue ARM Loans since they reduce the risk involved and allow them to match their sources of funding. The borrowers prefer ARM loans because of the low initial cost involved but the risk is high.


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