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The alternative to a fixed-rate loan is an adjustable-rate mortgage (ARM), which offers an interest rate that fluctuates based on the terms of your loan agreement. The rate on an adjustable rate mortgage typically is fixed for a period of time, after which it changes annually. That change in rate, and in payment, will be calculated based upon an index and a margin, with built-in caps.
For example, you may select a “5/1 LIBOR ARM with 2/2/5 caps”. In plain English, that means you selected a rate that would stay fixed for 5 years. In the sixth year, the rate will change, based upon certain parameters. In this example, that would be the value of the index , the one month LIBOR in this case, (London Interbank Offered Rate), which can be found daily on financial sites and periodicals, to which is added the margin of 2.25% (rounded up to nearest 1/8%), and it could not increase more than 2% at the first change, or 2% at any annual change after that, nor can increase more than 5% total over the life of the loan. So if you start at 3.5%, and the one month LIBOR is 2%, the new rate for one year would be 2% (the index) plus 2.25% (the margin), for a total of 4.25%. Since 4.25% is within the caps (not more than 2% over the 3.5% you started with), that is fine. One year later, the same calculation would be made, and so on.
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