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Libor ARMs: What are They and Why Select One?

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A Libor based Libor Basicsmortgage is an adjustable rate mortgage (ARM) in which the interest rate is tied to an index known as the Libor index. The term ‘LIBOR’ refers to the London Interbank Offered Rate, which is the interest rate at which a group of major London banks borrow money from each other. It is also one of the major interest rate indices used worldwide. The Libor index is also generally the interest rate offered by these banks on U.S. dollar deposits.

What is a Libor Mortgage?

A Libor mortgage is one for which the interest rate is determined by the Libor index. The initial rates are usually significantly lower than ARMs based on another index. They are provided with period caps, and also lifetime caps. The level of the cap will depend upon the individual mortgage, though some lenders offer a lifetime cap of 5% – 6%.

The Initial Libor Fixed Rate Period
The initial fixed rate period is set, where the interest rate is the Libor index at that time plus a margin. This period usually lasts between 6 months and 10 years. After the initial fixed rate period is over, the interest rate is set by the Libor index at that time. The rate then varies at agree periods, and is set to the latest Libor index at the end of each period.

Subsequent Adjustable Rate Periods
After the first adjustment at the end of the fixed rate period, subsequent adjustment periods are set. For example, a 5/1 ARM will have a fixed rate for the first 5 years, and the rate will then be adjusted to the latest Libor rate every year thereafter.

There is a rate cap applied to each adjustment, this being either 2% or 5%. A 3/1 Libor mortgage cap is set at 2% and a 7-year a 10-year at 5%. With 6-month Libors, the rate changes every 6 months, and with 30-day Libor the rate changes monthly.

There is also a maximum interest rate set. Some set the maximum at a level above the Libor index, such as the Libor rate + 5%. Others set it at a specific rate, such as 10%. If a cap does not permit a jump to the higher rate from one period to the next, it will be attained by the maximum permitted over a number of periods. For example, a 3/1 Libor starting at 5% with a 2% cap would require 2 annual increases of 2% and one of 1% to reach the 10%.

Benefits of Libor Mortgages

Libor mortgages allow you to select the best combination of initial and adjustable rates. You also know the maximum by which your interest rate can increase each period, and can budget for that. Another benefit is that Libors are generally positively amortized, meaning that your monthly payments will always cover the interest and part of the principal. Some mortgages do not meet the entire interest requirement, and none of the principal.

If you feel that a Libor mortgage might suit you, then contact a mortgage professional and discuss the matter. It may well your best option, but there might also be something better you may not know about.

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