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  • variable-rate mortgageadjustable-rate mortgage (ARM), or tracker mortgage is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets. The loan may be offered at the lender's standard variable rate/base rate. There may be a direct and legally defined link to the underlying index, but where the lender offers no specific link to the underlying market or index the rate can be changed at the lender's discretion. The term "variable-rate mortgage" is most common outside the United States, whilst in the United States, "adjustable-rate mortgage" is most common, and implies a mortgage regulated by the Federal government, with caps on charges. In many countries, adjustable rate mortgages are the norm, and in such places, may simply be referred to as mortgages.

    Among the most common indices are the rates on 1-year constant-maturity Treasury (CMT) securities, the cost of funds index (COFI), and the London Interbank Offered Rate (LIBOR). A few lenders use their own cost of funds as an index, rather than using other indices. This is done to ensure a steady margin for the lender, whose own cost of funding will usually be related to the index. Consequently, payments made by the borrower may change over time with the changing interest rate (alternatively, the term of the loan may change). This is distinct from the graduated payment mortgage, which offers changing payment amounts but a fixed interest rate. Other forms of mortgage loan include the interest-only mortgage, the fixed-rate mortgage, the negative amortization mortgage, and the balloon payment mortgage.

    Adjustable rates transfer part of the interest rate risk from the lender to the borrower. They can be used where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate falls but loses if the interest rate increases. The borrower benefits from reduced margins to the underlying cost of borrowing compared to fixed or capped rate mortgages.

    In some countries, banks may publish a prime lending rate which is used as the index. The index may be applied in one of three ways: directly, on a rate plus margin basis, or based on index movement.

    A directly applied index means that the interest rate changes exactly with the index. In other words, the interest rate on the note exactly equals the index. Of the above indices, only the contract rate index is applied directly.

    To apply an index on a rate plus margin basis means that the interest rate will equal the underlying index plus a margin. The margin is specified in the note and remains fixed over the life of the loan. For example, a mortgage interest rate may be specified in the note as being LIBOR plus 2%, 2% being the margin and LIBOR being the index.

    The final way to apply an index is on a movement basis. In this scheme, the mortgage is originated at an agreed upon rate, then adjusted based on the movement of the index.[1] Unlike direct or index plus margin, the initial rate is not explicitly tied to any index; the adjustments are tied to an index.

     

     

  • Overview

    The most important basic features of ARMs are:[3]

    1. Initial interest rate. This is the beginning interest rate on an ARM.
    2. The adjustment period. This is the length of time that the interest rate or loan period on an ARM is scheduled to remain unchanged. The rate is reset at the end of this period, and the monthly loan payment is recalculated.
    3. The index rate. Most lenders tie ARM interest rates changes to changes in an index rate. Lenders base ARM rates on a variety of indices, the most common being rates on one-, three-, or five-year Treasury securities. Another common index is the national or regional average cost of funds to savings and loan associations.
    4. The margin. This is the percentage points that lenders add to the index rate to determine the ARM's interest rate.
    5. Interest rate caps. These are the limits on how much the interest rate or the monthly payment can be changed at the end of each adjustment period or over the life of the loan.
    6. Initial discounts. These are interest rate concessions, often used as promotional aids, offered the first year or more of a loan. They reduce the interest rate below the prevailing rate (the index plus the margin).
    7. Negative amortization. This means the mortgage balance is increasing. This occurs whenever the monthly mortgage payments are not large enough to pay all the interest due on the mortgage. This may be caused when the payment cap contained in the ARM is low enough such that the principal plus interest payment is greater than the payment cap.
    8. Conversion. The agreement with the lender may have a clause that allows the buyer to convert the ARM to a fixed-rate mortgage at designated times.
    9. Prepayment. Some agreements may require the buyer to pay special fees or penalties if the ARM is paid off early. Prepayment terms are sometimes negotiable.