Adjustable Rate Mortgages, Types of ARMs and how they adjust.  

By Michael Mapes, host of www.theresponsiblemortgagelender.com

As A Mortgage Lender in Hampton Roads, Virginia, understanding the pros and cons to Adjustable Rate Mortgage can be difficult at best.  However, Adjustable Rate Mortgages when properly managed can be a good and wise investment.

Adjustable Rate Mortgages (ARMs) become more popular as interest rates rise, and for good reason they make sense.  They are, however, not without an element of risk. 

When interest are low....

• The spread between adjustable rates and fixed rates is small.
• The likelihood of the adjustable rate increasing is relatively high.
• Most borrowers prefer the safety and value of a fixed rate.

When Interest rates increase

• The spread between adjustable rate and fixed rate mortgages is greater
• The likelihood of adjustments is diminished.
• The advantage of an adjustable rate becomes more desirable.

Types of ARMs  

Many borrowers think of adjustable rate loans as the traditional 1/1, where the interest rate is fixed for only one year, and the rate adjusts each year every year thereafter.  While the 1/1 typically has a much lower first-year rate, its higher volatility must be carefully considered.

There is a wide variety of adjustable rate mortgages (ARMs).  For example, a 1/1 ARM is guaranteed for one year, and the rate adjusts every year thereafter.  You may prefer a hybrid ARM, where the initial rate is guaranteed for 3 years, then adjusts every your thereafter.  Depending on the loan you choose, you may be able to select from the following menu: 1/1, 3/1, 5/1, 7/1, or 10/1 loans.  All these loans are typically based upon a 30 year amortization.

Index and Margin  

The rate adjustments are based on two factors:  The Index and the Margin.  Many ARM products are based on the weekly average yield of the US Treasury Securities, adjusted to a constant one year maturity (The Index), plus the margin.  Some ARMs have a different index.

For Example:  Suppose a borrower has a 3/1 ARM based on the weekly average of US Treasury Securities and a margin of 2.75%.  Beginning with the forth year, the interest rate will adjust.  If the US Treasury Index is 5.5% and the margin is 2.75%, the new interest rate will be 8.25% (5.5 + 2.75 = 8.25%).  Each year thereafter the rate will adjust based on the US Treasury.

Remember, the initial rate of an ARM is usually lower than the current "index + margin rate.  Thus with no change in the underlying index rate, the first adjustment will likely be upward.  However, if interest rates decline, then there may be a rate decrease.

Rate Caps

Borrowers aren't completely unprotected during the rate adjustments.  Each ARM has a number of limitations on rate adjustments.

Lifetime Cap:  The maximum increase the interest rate can adjust over the life (term) of the loan.

Example:  if the initial rate is 7.5% and the life time cap is 6%, then the rate may never go over 13.5%

First Adjustment Cap:  The maximum increase that can take place on the first adjustment made to the interest rate of the loan:  for example the 3/1 ARM, This adjustment is made at the beginning of the fourth year can be as low as 1% or as high as the life time cap (typically 6%).

Adjustment Cap:  Following the first adjustment, this is the maximum the rate can increase or decrease at each subsequent adjustment of the loan.  Usually the adjustment caps are 2% on conventional loans and 1% for FHA and VA loans.

Floor:  This is the lowest the rate can go and varies by product.

Convertibility:  Many adjustable rate mortgages have a convertibility feature to them.  This allows the borrower to convert the ARM loan to a fixed rate with out the expense of having to refinance.  Terms of the convertibility vary by ARM product but many are based upon the FNMA yield plus a small margin.  The specific windows in which an ARM loan can be converted vary with product type. Although there is usually a fee associated with this conversion it is far cheaper than refinancing and having to re-qualify for a new loan.

Pre payment penalties -  Some ARMs may have a prepayment penalty in exchange for a much lower rate.  The penalty usually ranges in terms of 3 to 5 years.  If you are confident you'll keep the loan past the prepayment period then the advantage of the much lower rate might make sense.

Why Choose an ARM  

• It usually increases the level of borrower qualification.
• It provides a lower initial rate.  This works well for people who expect an increase in their pay over the next few years.
• It provides a lower rate than that of a fixed rate mortgage.
• An Arm makes sense for those people that want a low rate now or believe that fixed rates will decrease prior to the fixed rate period of the ARM ending.
• A little understood fact of an ARM is that when the ARM recalculates are adjusts it does so on what you owe, not what you borrowed.  This feature allows for "bulk" reduction in the amount borrowed to off set any rate adjustments.

An adjustable rate mortgage can make sense for a lot of reasons.  A Responsible Mortgage Lender will be able to help you decide which one is right for you.  While ARMs are not without Risk, but properly managed they can save you thousands of dollars over the long run.

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