Understanding Adjustable Rate Mortgages

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Here is some information about the Adjustable Rate Mortgage (ARM), understanding how the adjustments are made, when to consider using them and questions to ask a lender when considering an ARM.

A lot of people are ambivalent about using an ARM even though, financially speaking, it’s a great short term product. If you plan on staying in your home for less than 7 years, an ARM may be a good way to take advantage of a lower payment and by paying less interest to the bank.

Although today we mostly see fixed rate loan products, the ARM is still offered for mortgage loan programs. Back in the early 2000’s, mortgage interest rates were between 6% and 7%. An ARM was a great tool to offer someone a lower interest rate while waiting for fixed interest rates to drop again.

The ARM may be used to help people qualify for more money. As you probably know, the lower the interest rate, the lower the mortgage payment. Debt ratios are used by lenders to qualify people for a loan. The debt ratio is calculated by dividing the mortgage payment by the income: Mortgage payment is $1000. Income is $3000. $1000 divided by $3000 = 33%. Some programs allow up to a 43% debt ratio or higher. If the buyer has a debt ratio of 33%, it gives the buyer the ability to borrow 10% more debt to buy a larger home, avoid having to use a co-borrower or to avoid having to pay off a debt to qualify for a home.

Back at the turn of the century (that makes me feel old), ARM’s were available using several indices (plural of index) to dictate the interest rate of a loan and how it would impact the monthly mortgage payment. The most common indices used today are the CMT (Constant Maturity Treasury) Index, T-Bill (1 Year Treasury Bill) Index, COFI (11th District Cost of Funds) Index and the LIBOR (London Interbank Offered Rate) Index.

 There are 4 components to an Adjustable Rate Mortgage: Initial Rate, Margin, Index and Caps.

Initial Rate: The rate offered at the beginning of the fixed rate period for 6 months, 1, 2, 3 ,5, 7 or 10 years.

Margin:  The margin stays fixed. It’s the lowest percentage rate allowed. It can be 1.75%, 2.25%, 3.5%, or whatever the bank wants to use in order to guaranty some kind of return on the money.

Index: The amount added to the margin to determine the interest rate after the fixed rate period. This can be found wherever the indices are listed (online, newspapers etc.) and the percentage changes all the time. It can be .10%, .40%, 1.125%, or whatever the factors are that affect the indices at that given time (kind of how the stock market changes, based on several factors).

Caps: The maximum increase of a rate each time it changes and the maximum that the interest rate can go, over the life of the loan.

 When you see an ARM represented like this: 1/1, 2/1, 3/1, 5/1, 7/1 ARM or10/1 ARM, the bank is basically telling you that on a 7/1 ARM for example, the rate offered will be fixed for 7 years. The “1” in this case states that on a 7/1 ARM, after 7 years, the rate will change every year (every 1 year). If this were a 10/1 ARM, the rate would be fixed for 10 years and then change every year thereafter. What if the ARM looks like this? 5/2 ARM. This means the rate is fixed for 5 years and then changes every 2 years thereafter.

 Let’s use this example:

Margin: 2.25%

Caps: Initial 5% then 2% every year and 6% over life of loan

Initial Rate: 3.5%

Time for Fixed Rate: 3 years (3/1 ARM)

Adjusts every year after the 3 year fixed rate period

Index: changes daily

The formula will look like this: 3/1 ARM 5/2/6.

 The 3/1 ARM states that the initial rate of 3.5% will be fixed for 3 years and it will change every 1 year after that.

The first number (5) of the 5/2/6 represents how high the rate can go after the initial 3 years. It may jump to 8.5% (3.5% + 5%).

The rate however is calculated by adding the margin plus the index (Margin 2.25% + Index .50% = 2.75%). The rate will actually drop from 3.5% to 2.75%. The new rate of 2.75% will stay there for a year.

One year has passed now and I’ve enjoyed my rate of 2.75%, but now it’s time to find out the next new rate.

The second number of 5/2/6 represents how much the interest rate can change every year after the initial change: 2%. Every year thereafter, the rate can go up as high as 2% from the current rate. If my current rate is 2.75%, then the rate may jump to 4.75%.

Once again though, we have to look at the index and add it to the margin. Index is 2.75% plus margin of 2.25% = 5%. The cap is 2% plus the previous rate of 2.75%, so the maximum that the rate can go up is to 4.75%, not 5%. Thank goodness for caps!

The third number of the 5/2/6 represents the maximum percentage that the rate can go up over the life of the loan: 6%. In this case the rate can never go up any higher than 9.5% (3.5% + 6%).

Here’s how my rate changed over the course of 5 years:

Year 1 – Rate at 3.5%; Year 2 – Rate at 3.5%; Year 3 – Rate at 3.5%; Year 4 – Rate drops to 2.75%; Year 5 – Rate increases to 4.75%. The highest it can go is 9.5%. The change will occur every year for the remainder of the loan unless I refinance or sell the property.

I hope this information helps you the next time you decide to obtain an ARM or you obtain a product that only offers an ARM. It’s important to understand what you’re getting into. A lot of people lost their homes because they didn’t understand the product (or it wasn’t explained to them) and/or they didn’t realize that their payment could double after the initial fixed period.

Here are some questions to ask:

For how long will my initial rate last?

How often will my rate change after the initial fixed rate expires?

What is the cap during the life of the loan?

What is the cap each year after the initial rate change?

What is the margin?

Where can I find the Index?

Is there a pre-payment penalty and if so, for how long and what is the cost of the penalty if I choose to refinance or sell the property?

Can I refinance at any time?

Is the loan convertible to a fixed rate mortgage and if so, how much will it cost to do so?

Is the product available as a fixed rate and if so, what is the difference in payment?

Joe Petrowsky
Mortgage Consultant, Right Trac Financial Group, Inc. NMLS # 2709 - Manchester, CT
Your Mortgage Consultant for Life

Nice job with your explanation, this product is so often misunderstood, but I recommend it quite a lot, especially on Jumbo loans.

Jun 13, 2016 03:35 AM