It's been in the media a lot, homeowners losing their homes because they took out ARMs, or Adjustable Rate Mortgages, and they couldn't handle the payments after the loan rate adjusted at the end of the fixed period. In other words, a 5 year ARM will begin to adjust the initial interest rate at the end of five years. How does this work? A very common method is to add a margin to the current 12 month LIBOR rate, and use that to recalculate the rates at each adjustment period. What is LIBOR? It stands for London Interbank Offered Rate. Many ARMs add a margin of around 2.25% or so to the current LIBOR to set the new interest rate.
Example: When you took out your loan, the terms set the adjustments to begin 5 years in the future, and be 2.25% added to the LIBOR rate as determined on the day of the reset or adjustment. So, if the LIBOR on adjustment day is 5.5%, the new rate would be 7.75%. Check your ARM terms to see if LIBOR is used, or some other benchmark, but this is the most common. Also, your margin may be more than 2.25%, and this will be spelled out in your loan documents.
Now, let's say that your ARM is coming up for adjustment in December of 2010, and it was a 5 year ARM taken out in 2005. Looking at a historic chart of LIBOR rates, in December of 2005, the 12 month LIBOR was 4.8226%. So, if that were the rate today, and your margin is 2.25%, then your new rate would be more than 7%. But, guess what the LIBOR was on a recent day in August 2010. It was 0.91%. Adding 2.25% to that would adjust your rate to 3.16%. And, the LIBOR has been under or just around 1% this year so far.
So, don't panic. Just drag out those loan papers and see if what your loan margin is, and if it's pegged to the LIBOR. If not, check the benchmark that is being used, as it still may signal a "not so bad" ARM adjustment.