ARM BasicsThe Adjustment Depends On The Index

When you take out an adjustable rate mortgage (ARM), you agree to allow your lender to make periodic adjustments to the interest rate that you pay on the balance of your home loan. The mechanics of the adjustments come from the terms that you agreed to at the beginning of the loan. The most critical factor that influences the rate hike is the index. When it is time to adjust the new rate is determined by the sum of the index and a margin, also defined in your loan.

Your lender will select the index and margin that suits their purposes from one of many that are in everyday use as references for mortgage lending. The index will itself be influenced by external factors, many of which are interconnected. Lenders select their indices based on a concern to keep lending rates competitive and profitable; therefore they choose an index that they believe will reflect the state of the home loan market at the time your rate adjusts.

The Factors Behind The Index

Common indices are six-month Treasuries rate, one-year constant maturity Treasuries, Certificate of Deposit Index, and the six-month London Inter-Bank Offered Rate. In turn, these published rates come under the influence of the state of the economy and the actions of the Federal Reserve.

The Federal Reserve funds the lending industry by providing cash to the banks; these funds are the lifeblood of the economy, the banks borrow at a discount lending rate and then loan the funds to their customers at a retail rate, profiting on the difference. The Fed changes the discount rate to influence the economy, to forestall recessions, and to control inflation.

The economy influences the indices through the behavior of investors and the state of businesses. If businesses prosper, employment increases, and the economy expands, it creates demand for goods and services; this increases borrowing and banks increase their rates, which tends to push indices upward. If the economy contracts and businesses experience a downturn, they will cut costs and lay off workers, resulting in decreased demand for loans, influencing indices to drop.

Initial Rates And Following Adjustment Fluctuations

One of the most annoying hazards of having an ARM is rate watching whereby you fixate on the index before the adjustment date. If you have a mortgage that resets periodically based on a published market index the current level of that index becomes a focal point that grabs your attention and holds it.

You might assume that the interest rate on you ARM will adjust upward, but that is not necessarily the case. If the conditions are right, it may remain unchanged or reduce slightly. If you had an exceptionally low introductory rate, a drop is unlikely, but subsequent adjustments will track the changes in the index rate, which will fluctuate with the condition of the economy and the sentiment of the Federal Reserve Board.

Adjustable rate mortgages are an excellent way to get a competitive initial rate. Once the adjustments start they become something of an adventure; the fluctuations in the economy and the index that determines your adjustment set the extremes of the ride.