A Note on Adjustable Rate and Fixed Rate Mortgage Plans in the US

            
 
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Case Details:

Case Code : FINC048
Case Length : 14 Pages
Period : 1990-2007
Pub. Date : 2007
Teaching Note :Not Available
Organization : -
Industry : Banking
Countries : US

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This technical note provides insights into the adjustable rate mortgage (ARM) and fixed rate mortgage (FRM) products. It describes the different parts of ARM, types of ARM, points that should be taken into account before opting for an ARM, circumstances under which ARM is advisable, and the advantages and risks involved in ARM. The latter portion of the note talks about the FRM. It also discusses the positive and negative attributes of FRM.

Defining Mortgage Rate Plans

There are two popular mortgage rate plans offered by banks and financial companies to provide residential and commercial real estate loans. These include the adjustable rate mortgage (ARM) and fixed rate mortgage (FRM) plans.

ARM, also known as the variable rate mortgage or floating rate mortgage, is a loan in which the interest rate1 is adjusted periodically on the basis of an index based on a particular benchmark. This plan had been developed to ensure a steady margin for the banks and financial companies, whose own cost of funding would usually be related to the financial index.

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Consequently, payments made by the borrower may change over time with the change in interest rates. However, in the case of FRM, the rate of interest remains usually fixed during the entire tenure of the loan.

Despite the fact that the amount of principal and the interest paid each month may vary in the case of each equated monthly installment (EMI), the total payment remains unchanged, which makes budgeting easy for the borrowers.

Basic Parts of ARM

An ARM can be divided into four basic parts - index, margin, adjustment period, and interest rate.

Index
The interest rate on ARM plan is tied to a financial index (index). This index is essentially a movement of an objective economic indicator.

This index can be any one of the common indices that the lender ties the interest rate with. Some of the common indices include:

Constant Maturity Treasury (CMT or TCM): Constant Maturity Treasury rates or Treasury Yield curve rates depend on the market yields of US treasury securities and are provided by the Federal Reserve Board. These are calculated from quotes obtained by the Federal Reserve Bank of New York, from five leading US Government security dealers. The market yields are read from yield curve at maturities ranging from 1 month to 20 years. The US treasury interpolates the yields from daily yield curve of treasury securities. The curve is based on closing market bid yields of actively traded securities traded in the OTC market. (Refer to Exhibit I for the Treasury Yield Curve Rates in June 2007).

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1]  The interest rate is the rate of interest that is charged by lenders from the borrowers for borrowing their (lenders') money.
 

 

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