ARM Rate Indexes
Every ARM is tied to an interest rate index. An index has three relevant features:availibility, level, volatility. All the common ARM indexes are readily available from a published source, with the exception of one called the Cost of Savings Index, or COSI. In principle, a lower index is better for a borrower than a higher one. However, lenders take account of different index levels in setting the margin. A 3% index with a 2% margin provides the same FIR as a 2% index with a 3% margin. Assuming volatility is the same, there is nothing to choose between them. An index that is relatively stable is better for the borrower than one that is volatile. The stable index will increase less in a rising rate environment. While it will also decline less in a declining rate environment, borrowers can take advantage of declining rates by refinancing. The most stable of the more widely-used rate indexes is the 11th District Cost of Funds Index, referred to as COFI (not 'coffee'). Most of the others are significantly more volatile. These include the Treasury series of constant (one-, two-, or three-year) maturity, one-month and six-month Libor, six-month CDs and the Prime Rate. Another series known as MTA is a 12-month moving average of the one-year Treasury constant maturity series. MTA is a little more volatile than COFI but less volatile than the other series. An ARM should never be selected based on the index alone. That would be like buying a car based on the tires. But if an overall evaluation (see below) indicates that two ARMs are very close, preference could be given to the one with the more stable index. How the Monthly Payment on an ARM Is Determined: ARMs fall into two major groups that differ in the way in which the monthly payment of principal and interest is determined: fully amortizing ARMs and negative amortization ARMs. Fully Amortizing ARMs adjust the monthly payment to be fully amortizing whenever the interest rate changes. The new payment will pay off the loan over the period remaining to term if the interest rate stays the same. For example, a $100,000 30-year ARM has an initial rate of 5%, which holds for five years, after which the rate is adjusted every year. (This is referred to as a '5/1 ARM.') The payment of $536.83 for the first five years would pay off the loan if the rate stayed at 5%. In month 61, the rate might increase to, say, 7%. A new payment of $649.03 is then calculated, at 7% and 25 years, which would pay off the loan if the rate stayed at 7%. As the rate changes each year thereafter, a new payment is calculated that would pay off the loan over the remaining period if that rate continued. Negative Amortization ARMs allow payments that don't fully cover the interest. They have one or more of the following features: - Payment Rate Below the Interest Rate: The payment rate,which is the interest rate used to calculate the payment, maybe below the actual interest rate. If the payment rate is so low that the initial payment does not cover the interest, the result will be negative amortization. - More Frequent Rate Adjustments than Payment Adjustments: If, the rate adjusts every month but the payment adjusts every year, a large rate increase within the year will lead to negative amortization. - Payment Adjustment Caps: If a rate change is large and a payment adjustment cap limits the size of a change in payment, the result will be negative amortization. Virtually all ARM's are designed to fully
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