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Commonly known as an option ARM, an adjustable-rate mortgage is a type of loan that uses a variable interest rate. The interest rate changes periodically according to the index it is based on. The most commonly used indexes for an option ARM are the Cost of Funds Index (COFI), Treasury securities (CMT) and the London Interbank Offered Rate (LIBOR).
Some lenders may also use their own funds as an index instead of relying on the above indexes. A lender will choose to do this so that the lender has a steady profit margin because the cost of their funding is related to one of the indexes. Regardless of whether the interest rate is tied to an index or set by a lender, the payments of a loan will constantly change due to the varying interest rate.
The two distinguishable characteristics of an option ARM compared to other mortgage types are that there is a cap on charges and that they are tied to an index. Also common with an option ARM are initial interest rate discounts during the first year of the loan, which are offered as a promotional tool, and negative amortization. Some option ARM agreements require the borrower to pay a prepayment penalty if he or she pays off the loan earlier than expected.
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