“My loan officer recommended a Libor ARM, said it was a good deal. Is this true?”

It could be true. Libor ARMs may have lower margins than other ARMs because of their appeal to foreign investors. But that doesn’t necessarily mean that you will get the lower margin, or that if you do, it won’t be offset by some other feature of the ARM that disadvantages you.

I advise against selecting an ARM based on the index, or any other one feature. You don’t buy a car because of its tires. Like a car, ARMs have several important features, and you should select one because all the features add up to an attractive instrument.

Libor is short for the London InterBank Offer Rate, the interest rate offered for U.S. dollar deposits by a group of large banks, including some U.S. banks, in London. There are actually several Libors corresponding to different deposit maturities. Rates are quoted for 1-month, 3-month, 6-month and 12-month deposits.

A Libor ARM is an adjustable-rate mortgage on which the interest rate is tied to a specified Libor. After an initial period during which the rate is fixed, it is adjusted to equal the most recent value of the Libor plus a margin, subject to any adjustment cap.

For example, on April 26, 2004, one lender was offering a 6-month Libor ARM at a start rate of 3 percent, zero points, and a margin of 1.625 percent. The new rate 6 months later will be 1.625 percent plus the 6-month Libor at that time. If the Libor is (say) 2.625 percent, the new rate will be 1.625 percent + 2.625 percent = 4.25 percent. If the adjustment cap that limits the size of rate changes is 1 percent, however, the new rate will be the start rate of 3 percent + the cap of 1 percent = 4 percent.

Libor ARMs do have some special features:

Low Margins for A-Quality Borrowers: Libor ARMs were developed to meet the needs of foreign investors looking to minimize their interest rate risk on dollar-denominated investments. A foreign bank that buys the 6-month Libor ARM containing a 1.625 percent margin can borrow the funds it needs in the inter-bank market for 6 months at the 6-month Libor. The bank pays the depositor Libor, and it earns Libor + 1.625 percent on the ARM. The margin is locked in, except to the extent that changes in Libor are not fully matched by changes in the ARM rate because of rate caps.

Because of the reduced risk, investors in Libor ARMs are willing to accept a smaller margin than is common on other ARMs. On April 26, 2004, for example, the Libor margin available to A-quality borrowers was as low as 1.5 percent, compared to 2.25 – 2.75 percent on ARMs indexed to other series.

But not everyone can benefit from the low margin. On the same day that the lender cited above was offering a 6-month Libor ARM at 3 percent with a 1.625 percent margin, a subprime lender was offering a 6-month Libor ARM to borrowers with D-credit at 10 percent with a 7 percent margin!

Attractive Buydowns: On 30-year fixed-rate mortgages, borrowers can usually “buy down” the rate by 1/4 percent by paying about 1.5 points. I have seen 6-month Libor ARMs (which also have a term of 30 years) that allow the borrower to buy down the rate and margin by 1/4 percent for only 3/8 of a point. This is an incredible bargain, but the Libors that offer it may have an unusually high maximum rate.

No Negative Amortization: Libor ARMs don’t offer the payment flexibility, nor the associated risks, of negative amortization ARMs.

High Volatility: Libor is about as volatile as rates on short-term U.S. Government securities, and more volatile than the COFI, CODI and MTA indexes.

But don’t select a Libor ARM for its special features. Select it because all of its features in combination make it more attractive than the other mortgages you are comparing it to. It will be more attractive than the others if, during the period you expect to have the mortgage, the interest savings early in that period (relative to the other mortgages) outweigh the risk of possible interest rate and payment increases later on.

The best way to make such a judgment is by comparing changes in the interest rate and payment on the Libor ARM with those on other mortgages. Calculator 7b on my Web site makes it easy to do this on any assumptions you make about how market interest rates change in the future.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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