Adjustable Rate Mortgages:
How They Are Calculated and When to Use Them

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 rates 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 are higher...

• The spread between adjustable rate and fixed rate mortgages is greater
• The likelihood of adjustments is lower
• The lower introductory interest rate of an ARM becomes more desirable.

Types of Adjustable Rate Mortgages  

There are several types of adjustable rate mortgages.  You will typically see adjustable rate mortgages described as 1/1 ARM, a 3/1 ARM, a 5/1 ARM, a 7/1 ARM or a 10/1 ARM.  The first number tells you how long the initial interest rate will apply and the second number tells you how frequently the interest rate can be recalculated after that.  For example a 5/1 ARM with a 5.5% interest rate means that the interest rate of 5.5% is guaranteed for five years. 

After the first five years, the interest rate will be re-calculated each year based on the balance due on the loan at the time of re-calculation.  Your monthly payment is based on the balance of the loan spread out over 30 years.  In general, the shorter the introductory period, the lower the initial interest rate. 

How are Adjustable Rate Mortgages calculated?

When the period of the initial interest is coming to a close, the first thing borrowers want to know is how much their interest rate is going to change.  Unfortunately, you need to have the power to divine what market conditions will be like in three, five, seven or ten years to figure that out.

Typically, adjustable rate mortgages are determined by two factors:  The Index and the Margin. 

The Index is expressed as a percentage and is determined using a complex calculation based on the weekly average yield of the US Treasury Securities adjusted to a constant one year maturity.  Since the Index is based on changing market conditions, it's not possible to say what the index is going to be at a given time.  You can think of the Index like a dock on a lake; it moves up and down depending on the water level. 

The Margin is a fixed percentage that does not fluctuate over the lifetime of the loan.

Here's how a typical adjustable rate mortgage works.  Suppose a borrower has a 3/1 ARM with an Index 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 be re-adjusted depending on how the Index changes.

Remember, the initial rate of an ARM is usually lower than the current "Index + Margin" rate.  Thus even if there is 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.

Other Factors Involved in Adjustable Rate Mortgages  

Rate Caps

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

• Lifetime Cap:  The most the interest rate can increase over the life of the loan is 6%.  So if the initial interest rate is 7.5% then the rate can 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 with a 3/1 ARM, the adjustment is made at the beginning of the fourth year  and can be as low as 1% or as high as the life time cap (typically 6%) depending how much overall interest rates have changed.
• 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

Convertibility allows the borrower to convert the ARM loan to a fixed rate with out the expense of having to refinance.  Terms of the convertibility and the specific time frame in which an ARM  can be converted vary depending on your loan. 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 applies in the first 3 to 5 years and goes down the longer you stay in your loan If you are confident you'll keep the loan past the prepayment period then the advantage of the much lower rate might make sense.

Benefits of an Adjustable Rate Mortgage  

• An ARM is usually easier to qualify for.
• An ARM has a lower initial rate.  This works well for people who expect an increase in their pay over the next few years.
• The introductory period 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 go down before the fixed rate period of the ARM ends.
• Since an ARM recalculates on what you owe, not what you initially borrowed, making large payments in the introductory period can off set future upward 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.  Adjustable rate mortgages are not without risk but when properly managed they can save you thousands of dollars over the long run.