What is an Indexed ARM
An indexed ARM is an adjustable-rate mortgage, meaning its rate changes periodically. Borrowers typically pay a set margin above an underlying benchmark that resets at a regular interval, based on market conditions.
The benchmark for an indexed ARM typically is short-term Treasury bills, constant-maturity Treasuries or libor. Some also peg to prime rate or the 11th District Cost of Funds Index, as well.
Any indexed ARM loan stipulates the index upon which the loan is pegged, the set margin above the index, and how often the interest rate adjusts to match the index. Many also set a maximum interest rate over the life of the mortgage.
BREAKING DOWN Indexed ARM
Indexed ARMs usually have much lower rates than 30-year and even 15-year fixed-rate mortgages to compensate borrowers for the risk of rising rates during the lifetime of the loan. These mortgages help some borrowers in periods of declining interest rates, as their payments decline when this happens. However, they end up with unexpectedly high costs when rates rise.
Some adjustable-rate mortgages restrict the amount the interest rate can go up or down every time it resets. For example, say the ARM adjusts quarterly, and the index moved up 100 basis points during the quarter, to 4.5%. However, the loan stipulates that the loan can only rise 50 basis points a quarter. The loan’s previous interest rate of 5%, therefore, only can rise to 5.5%, and not 6%.
Indexed ARMs are the only type of adjustable-rate mortgages offered in the United States.
In Europe, however, there’s another type, called a discretionary ARM. This type of ARM lets lenders adjust the interest rate at any time for any reason, contingent only upon giving advance notice to the borrower.
In comparison, indexed ARMs provide more protection to the borrower, as the interest-rate adjustment is not based on the decision of a bank manager.
Pros and Cons of Indexed ARMs
Comparatively lower rates sometimes attract borrowers to indexed ARMs, especially first-time homebuyers who know they plan to live in a starter home for a fairly short time, say five years. In addition to a lower payment, indexed ARMs sometimes help borrowers build up equity relatively faster than with a 30-year mortgage.
This type of loan sometimes causes problems, however. Say the first-time homebuyer who planned to sell in five years suddenly can’t do without taking a huge loss because the neighborhood becomes labeled a cancer cluster. The homeowner then decides to stay in the home, rather than sell at a huge discount. if rates are rising the homeowner then must pay more on the indexed ARM loan each month, or refinance to a fixed-rate loan at a higher rate.