Are you confused about where an Adjustable Rate Mortgage (ARM) gets the interest rate? Does it seem that the rates are set by the banks? Is there any regulation of these rates?
ARMs are based on two figures, an “index” and a “rate”. The “index” is the rate at which the bank can borrow money from other banks. The Prime rate and the LIBOR (London Interbank Offer Rate) are two of the more widely known indexes. The second part of the final ARM figure is the rate. The “rate” is the percentage the bank expects to make on the ARM. The index and the rate combine to form your interest rate.
Example: if the “index” was 3% and the bank wanted to make 5% then your ARM starting rate is 8%.
3% (index) + 5% (rate) = 8% (ARM interest rate)
So when you hear of a loan that is “Prime plus 2” or something to that effect, then you’ll know that the loan is based on the Prime rate (index) + 2% for the bank.
This example describes the starting point of an ARM. The ARM interest rate (8% in this example) is adjustable based on the index. If the index goes up, then your ARM interest rate goes up.
Example: if the “index” went up by 1%, then:
4% (index) + 5% (rate) = 9% (ARM interest rate)
The bank does not increase the “rate”, or amount they want to make off the loan; but the “index” is the reason for the increase of the overall interest rate of an ARM loan. To prevent the interest rate from increasing too much, the ARM loan will specify that the ARM can’t be adjusted beyond a certain point. However, the range is usually rather wide. ARM loans are not inherently bad for consumers, but consumers that fail to understand how the rates can influence their monthly payments may find themselves in financial trouble down the road. Fortunately, there are many mortgage modification options for borrowers that need to find a way to lower their monthly payments when experiencing a financial hardship.