In brief, ARM is an acronym for Adjustable Rate Mortgage. An ARM is the most common mortgage used in Western culture in countries like the United States, Canada, and the U.K.

With an ARM the borrower’s (homeowner’s) interest rate on their mortgage fluctuates based on the current interest rate index used by the lending institution (subjectively). In some countries the index used is a national prime rate which is set by the central bank. In countries, like the United States for example, use different indices for their lending rate index.

Each United States lending institution may use a different set of ARM indices depending on how their lending practices are carried out. Usually the initial ARM rate on a  mortgage is 1-3 % above “the index rate” depending on your risk factor (whether or not you are a considered a sub-prime borrower by the bank)

The common ARM indexes (indices) for the USA are as follows:

• 11th District Cost of Funds Index (COFI) [common]
• London Interbank Offered Rate (LIBOR)
• 12-month Treasury Average Index (MTA) [common]
• Constant Maturity Treasury (CMT)
• National Average Contract Mortgage Rate
• Bank Bill Swap Rate (BBSW)

ARMs or Adjustable Rate Mortgages have been badly abused in the United States as predatory lenders have manipulated their borrowers into excepting ARM terms that include balloon payments and dramatically inflating rates over the term of the mortgage. These predatory practices have damaged the financial sector greatly as we all now know (crash of 2008).

Understanding ARM Terms if Finance

• IRC (Interest Rate Cap) – if there is a cap placed on an ARM note that means the interest rate can only be increased by an agreed amount, or what is legal in the jursidiction of the note’s initiation, at each pre-agreed adjustment point(s) in the term. These ARM caps are critical to watch as consumers have been badly burned by predatory lenders.
• Conversion – the bank or lender agree with the borrower that the ARM loan can become and fixed rate mortgage if the prime rate (or LIPOR, COFI, MTA, CMT, BBSW) looks like it may increase beyond a particular set rate. Terms of the ARM conversion are completely dependant on the lender’s policies and borrowers/homeowners should be fully aware of the conversion terms in their mortagage agreement before signing on with the bank.
• IIR (Initial Interest Rate) – very simple, in that this refers to the initial interest rate on the variable mortgage when the mortgage taker walks out the door of the bank and gets ready for their first intallment.
• The Index Rate – we discussed this above as what private lenders and banks use as their starting point for the financing they provide to property owners. When the lenders index rate jumps a 1/4 point so to will your ARM depending on the terms of your agreement. The most common indices used in the United States are the COFI (cost of funds index), and the 1-5 year Treasury Security average rate.
• Rate Margin – this is where the banks make their profit friends. So if the lender’s index rate is at 3% and they charging you 5% at a particular term of your ARM, then your margin would 2%.