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With so many different loan programs available to you, it is important to have the information you need to help you decide which mortgage loan is best for you. One type of loan you may want to consider is an ARM loan.
ARM stands for Adjustable Rate Mortgage. If you have an ARM loan, the annual percentage rate of the loan may increase or decrease after the loan is closed. By contrast, a fixed rate loan has a rate that remains constant throughout the term of the loan. An ARM loan usually has a lower initial interest rate, making it look more attractive than a fixed rate loan. Your loan officer will explain these differences to you.
INDEXES: The rate on ARM loans are usually based on an index. An index follows the overall condition of the economy and is a measurement of the relative cost of funds at any given time. Generally, the interest rate on an ARM loan rises when an index increases and falls when an index decreases. Some examples of different indexes include: the Wall Street Journal Prime Rate, the weekly average yield on U.S. Treasury Bills, or various cost of Funds Indexes.
Some ARM loans are not based on an index. For these loans, adjustments are left up to the lender, who adjusts the rate according to market conditions. The rates for these loans are usually comparable to loans that are tied to an index. Market forces keep them from getting out of line.
The interest rates on adjustable rate mortgage loans that are tied to indexes are generally determined by the addition of a margin.
A margin is a pre-determined amount that is added to, (or, in some cases, subtracted from) an index value in order to arrive at an interest rate. For example:
Using the above example, if at the next interest rate adjustment, the index value fell to 3.98%, then the interest rate would fall to 5.98%.
Often the interest rate is subject to one more minor adjustments known as "rounding". With rounding, the interest rate is adjusted to a pre-set increment, for example the nearest one-eight of one percent (0.125%). In the example above, after the adjustment the interest rate (5.98%) would be 6.00%. Now you see how a margin affects the interest rate.