As if there were not enough decisions to make when you are buying a house and getting a mortgage, lenders now have such a wide rang of ARMs (adjustable rate mortgages) and the borrower even has to decide upon the index upon which the ARM will be based!
When we speak of the “index”, we are speaking of the base financial instrument that the adjusting rates will be based on. Today, banks use various indices, such as the rate on government debt, or the Fed Fund interest or the London Interbank Offer Rate(LIBOR).
Interest rates on ARMS adjust, upwards or downwards, based on how overall rates are moving, which is reflected in the movement of the underlying index rate. For example, if you chose the CD rate as your index, when CD rates increase, your home loan rate will increase. ARMS also have adjustment caps, so that you can limit the exposure as to how high your mortgage rate can go, even if your index rate continues to increase, which is good if you just had a change, and the rates increase again. It can be a disadvantage if you have just readjusted, and afterwards there is a downward movement, however.
The list of instruments that ARMs can be tied to reads like alphabet soup nowadays, from CDs to LIBOR. The Fed Funds rate is another very popular basis for ARMs. LIBOR is the London Interbank Offered rate, which is the rate that commercial borrowers pay each other to borrow money.
Which is the right choice depends on your situation circumstances and your view of the direction of interest rates. If you prefer a rate that is responsive to the interest rate market, you would choose the CD rate as your benchmark. On the other hand, if your ARM is based on T Bills, it will move more slowly. One of the fastest indices to change is the LIBOR, so if you want your interest rate to move frequently, because you think rates are going to decrease, this is a good choice.
But in addition to these standards, new products are always been introduced on the mortgage market; an example would be the option ARM, which lets a borrower decide how much mortgage he is going to pay each month! Of course, there is a minimum, usually the amount of interest, so the lender can guarantee its return, and then the balance goes toward the loan. People using this option should be careful about negative amortization, because they may never repay any of the loan if they always choose the lowest amount.
This is a lot of information for the home buyer to digest, and the best solution is to consult with a professional mortgage broker who can explain it all and recommend the best course for you.