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James R. DeBoth President--Mortgage Market Information Services, Inc.
You probably already know that an adjustable rate mortgage (ARM) is one where the rates are adjusted up or down at predetermined times. However, do you know what it actually takes to bend your ARM? Do you know on what the adjustments are based?
There is no set rule for an ARM. A lender can use almost anything as a basis for the adjustments-as long as the borrower knows about it and agrees to it in advance. Approximately 80 percent of all the ARMs in the United States today are based on one of three different financial indexes, according to Frank Demarais, the Vice President for Product Development at Fannie Mae. Fannie Mae is a federally chartered stockholder owned corporation that purchases mortgage loans in bulk from mortgage lenders.
You can find these indexes in the financial pages of many newspapers, or on the Internet. Thus, you can keep track of the index on which your ARM is based. This will help you to determine if your mortgage rate is going to go up or down the next time it gets adjusted. It can also help you figure out if you should look for a fixed-rate mortgage in order to refinance your loan.
The most commonly used index is the Constant Maturity Treasury (CMT), according to Demarais. The CMT is often referred to as the T-Bill or Treasury Bill rate. Before giving details about the CMT, we have to look at how the federal government borrows money. When the government borrows money for lessthan one year, the people it borrows the money from get a Treasury Bill, or T-Bill, as their promissory note. If the loan is for between one and 10 years, the loan is called a T-Note, and if it is for more than 10 years it is called a T-Bond. The CMT isn't a single security or note. It is the average of the interest rates of all the treasury debt that is maturing in the coming 12 months, Demarais says. So you compute the average interest rate for all of these loans in order to come up with the CMT.
Demarais says that many ARMs offer a low rate as a "teaser or inducement" for the first six months or year, or maybe even longer. After the introductory period is over, the loan will be pegged to the CMT, plus a specified interest rate (margin). In many cases it will be the CMT, plus two-and-one-half percent. This depends upon your lender and your own individual loan. The lender has to figure out a safe rate that will guarantee a profit and still be competitive with other lenders. Roughly half of all ARMs are based on the CMT.
Next comes the Cost Of Funds Index (COFI).There are 12 federal Home Loan Banks in the U.S., each one responsible for one of 12 federal bank districts. They loan money to banks. Demarais says many lenders use the 11th District COFI, which is the figure from the San Francisco branch. It calculates the costs, or interest rates, of the borrowings and advances made by member banks. Demarais points out that "the COFI is not tied to the CMT. It's a blend of all the borrowing the banks do. The benefit of the COFI is that it moves very slowly, while the CMT moves with the world market. The COFI smoothes out a lot of the volatility of the market."
Next comes the London Interbank Offered Rate (LIBOR). It is an average of the rate banks charge one another when they loan money internationally on a short-term basis. Let's say a bank in Mexico needs several million dollars for two weeks. It might borrow it from a bank in Australia, or anywhere else in the world. The LIBOR changes daily, even hourly in some cases. There are also several different LIBOR rates, so if your ARM is based on a LIBOR, the loan must specify which one is being used. As with the CMT, the LIBOR is more open to quick and wide fluctuations than the COFI rate.
Regardless which index your lender uses, the loan papers will spell out what the rate is and how many percentage points higher than the index your rate will adjust to at a specific time on a specific date. No matter which index is being used, most ARM rates are pretty much within the same range. Demarais explains that a lender "might offer you a rate at 2 percent over LIBOR or 2.5 percent over CMT." However, since LIBOR is often half a percent more than the CMT, your cost will usually be about the same.
Aside from the various indexes on which an ARM can be based, there are different types of ARMs. Some offer a low rate for the first six months or a year, and then they are adjusted every year. Others, called fixed-rate ARMS, will offer a fixed rate for the first two, three, or more years before climbing, or dropping, to a rate based on one of the indexes.
Some lenders use other indexes, such as the six-month T-Bill rate.
Others may use a figure based on the certificate of deposit (CD) six-month, or one-year index. Demarais also points out that "most mortgages are refinancable at the option of the consumer, without any penalty. So consumers can agree to an ARM today, and when they see rates that they like, they can refinance for a fixed rate mortgage."
Finally, Demarais advises borrowers to "be very careful, read everything very carefully, and spend some time becoming comfortable with the ARMs. Also, find out where you can find the index on which your loan is based." That way, when it's time for your ARM to bend, you'll know if it's bending up or down.
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