Adjustable Rate Mortgages - Determining Rates

Adjustable rate mortgages are to home buyers as carrots are to

bunnies - very tempting. The secret to figuring out if an

adjustable rate mortgage is a good deal is the rate index used.



Indexes - Setting Rates



Lenders really want your business and are willing to create

enticing loan products to get it. Occasionally, lenders will

offer adjustable rate mortgages that offer a lot of carrot on

the front end, but none on the back end. These loans are

typically offered to you with an insanely low initial interest

rate, which has you looking at mansions and other structures

completely out of your realistic price range.



The problem with

these loans is the rate rises dramatically after six months or a

year when the rate becomes pegged to an index.



Indexes are a unique animal when it comes to the mortgage

industry. An index is a calculation of general interest rates

charged across a number of financial markets that a bank uses to

set a real interest rate on your loan. Common financial markets

or products considered in this index include six month

certificate deposit rates at local banks, LIBOR, T-Bills and so

on.



Let's take a closer look.



1. Certificate Deposits - Better known as "CDs", these are the

fixed time period investing vehicles you can get at your local

bank. You agree to deposit a certain amount for six months and

the bank gives you a guaranteed interest rate of return such as

three percent.



2. T-Bills - Officially known as Treasury Bills, T-Bills are the

credit cards for the federal government. Currently, Uncle Sam

owes trillions of dollars on his and pays a certain interest

rate on the debit.



The interest rate is used by lenders in

calculating your ARM rates.



3. Cost of Funds Index - It gets a bit technical, but this index

represents the rates being used by banks in Nevada, Arizona and

California as an average.



4. LIBOR - Officially known as the London Interbank Offered Rate

Index, LIBOR is a popular index upon which to base ARM rates.

Now, you are probably wondering what London has to do with the

United States real estate market. LIBOR represents the interest

rate international banks charge to borrow U.



S. dollars on the

London currency markets. LIBOR rates move quickly and can result

in unstable interest rate moves for your adjustable mortgage.



Why Indexes Matter



Indexes matter because they set the base of the interest rates

charged on your loan. Assume you apply for an adjustable rate

mortgage based on a LIBOR index. Assume the LIBOR rate is 2.2

percent when you apply. The 2.2 percent is your starting

interest rate. If the LIBOR shoots up one percent in eight

months, your loan will do the same.



Importantly, the index rate used for your loan is not the

interest rate you will pay. Instead, you have to add the banks

margin on top of the index rate. Most banks will charge two to

three percent on top of the index rate. Using our LIBOR example,

the initial interest rate of your loan would be 2.2 percent plus

whatever the bank is using as a spread. Obviously, this means

you need to closely read the loan documents to figure out how

the game is being played!