Favoring an ARM Loan

ARM loans, which stand for adjustable-rate mortgages, are designed with an interest rate that changes. An ARM may start out with a lower interest rate than a comparable fixed rate loan. As interest rates go up, the interest rate for an arm increases. As interest rates go down, the interest rate in the arm declines, although not always at the same rate.

LIBOR Rate

ARMs are pegged to some underlying interest-rate index such as the London Interbank Offered Rate or LIBOR. As the LIBOR index changes, adjustments are made to the ARM to correspond with the changes. This results in higher interest rates when the LIBOR is up and lower interest rates when the LIBOR is down.

Interest Rate Outlook

A borrower favoring an ARM is betting on an interest rate outlook that is generally low or predicted to trend lower over a long period. Lower interest rate periods in an ARM over 5, 10, or even 30 years translates in huge savings with an ARM loan as compared to a fixed rate loan. ARM do not normally have caps or floors in the amount of interest it credits to the loan so the range of interest rates can be from 0 to infinity.

ARMs for Short-Term Borrowing

Some ARMs have prepayment penalties attached to the terms of the loan. They are more advantageous for short-term borrowing of less than 5 years, where interest rate trends are more predictable. Changes in interest rates that trend lower make an ARM ideal for a borrower with a short-term need for financing and a desire to pay a lower interest rate cost. ARMs that are longer than 5 years lose the predictability of the interest rate market and may subject the borrower to greater risk.

Refinancing an ARM

A borrower can take advantage of lower interest rates in an ARM by taking out the loan and refinancing to a fixed-rate loan option after 5 years. Some ARMs are designed to offer a periodic change to a fixed-rate loan option at certain intervals. This option allows the borrower to enjoy the benefits of an ARM while interest rates are going down and lock in a fixed rate when interest rates are rising. This is done without having to incur additional loan application and processing fees.

ARMs provide a way for savvy borrowers to take advantage of changes in interest rates. The borrowers understanding of interest rates and constant monitoring of the LIBOR or underlying index to ensure that if interest rates begin to rise, there is a way to capture a lower rate or freeze the ARM at a guaranteed fixed-rate option makes the ARM a suitable choice.