In addition to the many decisions you have to make when you are choosing a mortgage, such as whether to go fixed or floating rate, how much down payment to make and how many points to pay, lenders have further complicated everything by offering a wide range of choice of indexes for ARMs (adjustable rate mortgages).
The index of an ARM (Adjustable Rate Mortgage) is the financial standard upon which the adjustments will be made. Indices can include the CD rate, the Treasury Bill rate, the Fed Funds rate, the LIBOR rate and, the new kid on the block, the options ARM.
The basic idea of an ARM is that the interest on the loan is adjusted up or down, periodically, based on a chosen signal interest rate that is indicative of interest rates in general. If your ARM is tied to the CD rate, and the bank’s CD rate goes up, your interest rate will likewise go up. ARMs have rate adjustment caps, so that the rate on your home loan will only go up at certain intervals (every three or six months, for example), so that if the CD rate goes up, you may not have an increased rate for a few months, if your rate just adjusted recently. It can be a disadvantage if you have just readjusted, and afterwards there is a downward movement, however.
There are a large number of ARM indices, and they include the CDs, LIBOR and government bonds mentioned. The Fed Funds rate is one of the most popular basis for ARMs. Another popular index used by many is the LIBOR, or the London Interbank Offered Rate, which well rated international companies pay to borrow.
Which is the right choice depends on your situation circumstances and your view of the direction of interest rates. CD ARMs change every six months, for example, and therefore react more readily to interest rate changes. On the other hand, if your ARM is based on T Bills, it will react more slowly. LIBOR is one of the quickest moving indices, so if you want to take advantage of quickly falling interest rates, this is the one to use.
But in addition to these standards, new products are always been put on the market; an example would be the option ARM, that will let a homeowner decide how much mortgage he is going to pay each month! There is a minimum payment that allows for the interest (so the bank gets its money) and then the other options will pay down some portion of equity. Be warned that minimum payment option can end up in an increasing, rather than decreasing mortgage, a concept known as negative amortization.
With this dizzying choice in interest rate scenarios for your mortgage, the best idea is to meet with a mortgage consultant who can explain all of them to you and advise you best on your needs.