Question

In: Economics

10. What two factors determine the interest rate for an​ ARM? How might this differ from...

10. What two factors determine the interest rate for an​ ARM? How might this differ from the initial​ rate? Why are the factors of rate caps and adjustment intervals​ important?

Solutions

Expert Solution

ADJUSTABLE RATE MORTGAGE

Meaning :

It's a variable rate of mortgage or tracker mortgage wherein the interest rate on the periodically adjusted based on an index which tells about the cost to the lender of borrowing on the credit market ,loan can be given at lender's standard variable rate

Two factors to determine ARM :

  1. INDEX - it is an established benchmark interest rate which shows the general market conditions, overall this index is depended on the market
  2. MARGIN - when index changes along with the loan's margin will give new interest rate( it gives number of percent point to be added to the index to set interest rate for ARM rate)

Difference from initial rate of interest :

Where for the initial rate of interest ,it is that rate of interest that is set when you take out the loan and will not change and unlike ARM ,the initial rate of interest will stay same for months,one year,or few years.Further it is often known as teaser rate as on adjustable or floating rate of loan ,it is often lower than ARM interest rate

Importance of rate caps and adjustment intervals:

  1. ​​​​​​Rate caps- it helps to determine the level of increment that the interest rate could witness i.e. how much can the interest rate will rise from the initial in the life time of the loan. It is most commonly of five percent which always brings a limit to the rise in interest rate not making it higher more than 5 % from initial.However in actual market some lender's do charge high
  2. Ajustment interval - it tends to determine the time period after which the interest rate has to be adjusted normally it's one year

CONCLUSION :

ARM rate is generally higher than that of initial wherein it is changing rate unlike initial .

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