An Index Can Make Or Break Your ARM

Last week I met with some borrowers who are doing a 7/1 LIBOR ARM. They understood the 7 year ARM part, but they weren’t quite sure what the “one” and the LIBOR meant. As a refresher, the seven year ARM basically means the rate is fixed for the first seven years. It will then adjust after that. This is where the “one” comes into play. For this particular loan the rate will adjust every year (hence “one”). How will the rate adjust? Well, the adjustment will depend on the value of the LIBOR index at the time of adjustment. The final interest rate is calculated as the value of the LIBOR index plus a pre-determined margin.

LIBOR stands for London Inter Bank Offered Rate. It is the average of the interest rate charged when dollar denominated deposits are traded between banks in London. There are many types of LIBORs differentiated by the time period. There is the one-month, the three-month, the six-month and the one-year LIBOR.

ARM WrestlingIn the aforementioned example the one year LIBOR was used for the index. So, the rate after the first seven years would be calculated as the margin plus the value of the one year LIBOR on the day of adjustment. The rate would then be fixed for the next year.  Another popular loan program is the 5/6 LIBOR ARM. Where the rate is fixed for the first five years and during the adjustment period it changes every six months depending on the value of the six month LIBOR at that time.

Now the final question is regarding the margin. The margin on the ARM is determined by the lender at the time of close. So this can vary between different programs and across different lenders. For example, the one-year LIBOR is at 5.365% today. If the lender was charging a 1.50% margin then your rate would be 6.875%. For the initial seven years this rate would stay fixed. Once the adjustment period arrived the rate would then change based on the value of the one year LIBOR on the day of adjustment. 

There are of course many indexes with different characteristics. Some indexes are better during periods of rising interest rates and others are better during periods of falling rates. Indexes such as the 12-Month Treasury Average are a bit more stable compared to the one month-Libor. It all depends on the loan, the lender and the type of ARM being offered. To learn more about indexes follow this link or call me and I can help you understand this little talked about feature on your adjustable rate mortgage.

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