What
is an Adjustable Rate Mortgage (ARM) and who can benefit from it?
Adjustable Rate Mortgages (ARM)
1Year
ARM, Caps of 2/6?
An Adjustable Rate Mortgage is a mortgage loan in which
·
The interest rate adjusts periodically according to a predetermined index and
margin.
·
The adjustment of the interest rate results in the mortgage payment either
increasing or decreasing.
·
Periodic adjustments to the interest rate can occur every six months, every year
or in multiple years.
·
ARMs typically have a lower initial interest rate vs. fixed.
·
There are ARMs that have fixed periods for 3, 5, 7 or even 10 years before the
interest rate starts adjusting (Hybrid ARM)
ARM
Terminology
Initial
Rate
The rate at which an ARM program begins is called the initial rate. The initial
rate and payment amount on an ARM will remain in effect for a limited period of
time. The initial rate can range from 1 month to 5 years or more.
Adjustment Period
The interest rate and monthly payment change every month, three months, six
months, 1 year, 3 years, 5 years or 7 years or so. The period between rate
changes is called the adjustment period. For example, a loan with an
adjustment period of 1 year is called a “1year ARM” and the interest
rate and, therefore, payment can change once every year. Remember, the interest
rate’s change could be positive or negative, it means at the next adjustment
period, depending on the market, the interest rate could be higher or lower than
the existing interest rate.
Index
The index is what the lender uses as an instrument for measuring changes in
interest rates. It is the lender’s barometer of change in interest rates.
Increases or decreases in the index cause the ARM payment to increase or
decrease accordingly.
Prevailing indexes include:
• 1 Year Constant Maturity Treasury Rate (CMT)
• 11th District Cost of Funds Index – COFI.
It is also known as San Francisco 11th District Cost of Funds Index
– COFI.
This
is
often used as an index for adjustablerate mortgages
• London Interbank Offered Rate  LIBOR
Margin
The percent added to the index in order to calculate the payment interest rate.
The Margin is the profit the lender will make above the index. The margin never
changes during the life of the ARM.
Fully Indexed Rate
The fully indexed rate is equal to the margin plus the index and is usually to
the nearest oneeighth of a percent. For example, if the lender uses an index
that currently is 1% and adds a 2% margin, the fully indexed rate would be:
Index
=1% +
Margin =2%
=============================
Fully Indexed Rate =3%
Discounted Initial or Indexed Rate (“teaser rate”)
If the initial interest rate on the loan is less than the fully indexed rate, it
is called the discounted initial or indexed rate. A lower interest rate
is offered by the lender during the first year or more of the loan. These
interest rate concessions are used as incentives to attract borrowers to ARM
products.
Interestrate caps
An interestrate cap places a limit on the amount the interest rate can increase
or decrease. Rate caps limit how much interest can be charged. Interest caps
come in three types:
Per Adjustment Cap
·
This caps limits how much a payment may increase or decrease in any subsequent
adjustment. In most cases, lenders base the per adjustment cap off the initial
or start rate. No matter what the Index + Margin calculates to at the time of
adjustment, the per adjustment cap applies.
Lifetime Cap
·
This cap is the limit the interest rate increases over the life of the loan.
This is a worst case scenario. The highest the payment will ever go to no matter
what the Index and Margin add up to.
Initial Adjustment
Cap
·
ARM’s that offer a fixed rate period during the first years of the loan usually
have an initial rate cap that is higher than the per adjustment cap. In many
ARM’s the interest payment rate may increase as much as 6% higher than the first
year rate.
ARM Cap Terminology
1/4 ARM
– 1% per adjustment cap and a 4% lifetime cap
2/6 ARM
– 2% per adjustment cap and a 6% lifetime cap
4/2/6 ARM
– 4% initial adjustment cap, 2% per adjustment cap and a 6% lifetime cap
Example: 1Year ARM, ARM Caps of 2/6. How does the ARM work?
The
11th District Cost of Funds (COFI) is often used as an index for adjustablerate
mortgages. At the time of writing this article, the
COFI rate was 0.999%. Let’s assume 1%
If the index is 1% and the lender’s margin is 2% on a 1year ARM, the
fully indexed payment rate would be 3% (1% + 2%) during the first year.
If the caps are 2/6, the most the interest rate could move up after the first
year would be 5% (3% initial rate plus 2% adjustment cap). Depending on what the
index does after the first year, the actual interest rate could in fact be
lower, but the maximum it could adjust upward is 5%.
Also, the maximum the interest rate could move for the entire life of the loan
would be 9% (3% initial rate plus 6% lifetime cap). If the index increased the
maximum every year, the borrower could reach the 9% maximum in the 4th
year (this is the worst case scenario).
Advantages of ARM Loans
1.
Lower initial interest rate:
The initial rate of interest will almost always be considerably lower
than the best fixed rate mortgage deal in the shortterm. Please note and
emphasize on the key points here: ARM Initial rate for a short period of time
will be lower than the best fixed rate at the time.
2.
The low initial low ARM
can help borrowers
who are currently struggling, but are confidence to experience income growth
later in their professional career.
3.
Higher Loan Amount:
The low introductory or initial rate allows a home buyer to borrow a larger sum
of money and purchase their dream home because home mortgage payments are
initially considerably lower.
4.
If Rates
Falling:
If the interest rates fall or stay low at the time of
Adjustment
Period, the home buyer benefits financially. The more rates fall down or the
longer they stay low, the more financial benefit to home buyer.
Disadvantages of ARM Loans
1.
More Long Term Cost:
While the initial
interest rates are lower than rates on fixedrate loans, an ARM mortgage loan
could actually cost the borrower much more over the full duration.
2.
Unpredictable Home Mortgage
Payment:
Unlike the fixedrate mortgage interest, the rate of interest is not set and
could go up a lot during the loan term. This could make it difficult for those
who are on a fixed income to cope with rising payments when banks rates start to
go up.
Warning: More Foreclosure.
For the above reason, foreclosure rates have always been a lot higher on ARM’s
than fixedrate deals.
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