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Understanding Adjustable Rate Mortgages (ARMs)

mortgageAn ARM, short for adjustable rate mortgage, is mortgage on which the interest rate is not fixed for the entire life of the loan. The rate is fixed for a specified period at the beginning, called the “initial rate period”, but after that it may change based on movements in an interest rate index. ARMs are contrasted with fixed-rate mortgages on which the interest rate quoted holds for the entire life of the mortgage.

Because ARMs have multiple features, they’ve always been a hard sell. These multiple features make them complicated, and complexity doesn’t sell well. Loan officers try gloss over complexities by focusing on one feature that they can use to hook the prospect. You will thus see ARM hooks expressed in such terms as “low”, or “stable”, or “interest-only”.

Ultimately, you’ll need take responsibility for the purchase decision. It’s your money, after all. Arm yourself with knowledge so you’ll know the right questions to ask the loan officer. The following sections offer a quick rundown of all the critical pieces that you will need to make an informed decision.

Initial rate and adjustment period

ARMs are usually advertised as 3/1, 5/1, 7/1, 10/1 or some similar configuration and each of these will also have a corresponding rate advertised (e.g. 6%, 6.125%, 6.25% and 6.375%). These are most commonly known as hybrid ARMs (see details below). What do these numbers mean?

The numbers used refer to the period for which the initial rate holds, and the rate adjustment period after the initial rate period ends. On a 3/1, for example, the 6% rate holds for 3 years, after which the rate adjusts annually based on a specific rate index.

How is interest rate in an ARM determined, after the initial rate period ends?

The rate Index

Lenders base ARM rates on a variety of indexes. Among the most common indexes are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). A few lenders use their own cost of funds as an index, rather than using other indexes. You should ask what index will be used, how it has fluctuated in the past, and where it is published.

ARM_3

The interest rate that applies to an ARM after the initial rate period is made up of two parts: any one of the indices enumerated above and the margin. The index is a measure of interest rates generally, and the margin is an extra amount that the lender adds. Your payments will be affected by any caps, or limits, on how high or low your rate can go. If the index rate moves up, so does your interest rate. In most circumstances you will probably have to make higher monthly payments. On the other hand, if the index rate goes down, your monthly payment could go down.

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The margin

To set the interest rate on an ARM, lenders add a few percentage points to the index rate, called the margin. The amount of the margin differs from one lender to another, but it is usually constant over the life of the loan. The fully indexed rate is equal to the margin plus the index. If the initial rate on the loan is less than the fully indexed rate, it is called a discounted index rate.

Interest rate caps

An interest-rate cap places a limit on the amount your interest rate can increase. Interest caps come in two versions:

  • A periodic adjustment cap, which limits the amount the interest rate can adjust up or down from one adjustment period to the next after the first adjustment

  • A lifetime cap, which limits the interest-rate increase over the life of the loan. By law, virtually all ARMs must have a lifetime cap.

Payment Caps

In addition to interest-rate caps many ARMs limit, or cap, the amount your monthly payment may increase at the time of each adjustment. For example, if your loan has a payment cap of 7%, your monthly payment won’t increase more than 7% over your previous payment, even if interest rates rise more. Let’s assume your monthly payment in year 1 of your mortgage was $1,000. With a cap of 7%, the maximum amount it could go up to would only be $1,070 in year 2. Any interest you don’t pay because of the payment cap will be added to the balance of your loan. A payment cap can limit the increase to your monthly payments but also can add to the amount you owe on the loan. (See negative amortization.)

Types of ARMs

Hybrid ARMS. These loans are a mix, or a hybrid, of a fixed-rate period and an adjustable-rate period. The interest rate is fixed for the first few years of these loans, 5 years in a 5/1 ARM, for example. After that, the rate may adjust annually (the 1 in the 5/1 example) until the loan is paid off. The first number tells you how long the fixed interest-rate period will be, and the second number tells you how oft en the rate will adjust after the initial period. You may also see ads for 2/28 or 3/27 ARMs. The first number tells you how many years the fixed interest rate period will be, and the second number tells you the number of years the rates on the loan will be adjustable.

Interest-only ARMs. An interest-only (I-O) ARM payment plan allows you to pay only the interest for a specified number of years (typically 3-10). This allows you to have smaller monthly payments for a period. After that, your monthly payment will increase even when interest rates stay the same because you must start paying back the principal as well as the interest each month.

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Payment option ARMs. A payment-option ARM allows you to choose among several payment options. These options typically include:

  • A traditional payment of principal and interest. The amount you owe on your mortgage is reduced with each payment.

  • An interest-only payment. The amount you pay only covers interest and none of it is applied to the principal. The amount you owe does not decrease with each payment.

  • A minimum (or limited) payment that may be less than the amount of interest due that month often described as negative amortization.

Negative amortization

Negative amortization means that the amount you owe increases even when you make all your required payments on time. It happens whenever your monthly mortgage payments are not large enough to pay all of the interest due on your mortgage. This usually happens when your loan has a payment cap and interest rates to a point where the amount owed for interest exceeds the cap. Unpaid interest is added to the principal on your mortgage and you will owe more than you originally borrowed.

Prepayment penalties

Some ARMs may require you to pay special fees or penalties if you refinance or pay off the ARM early. These prepayment penalties may be “hard”, meaning that you have pay a fee if you pay off the loan during the penalty period for any reason (because you refinance or sell your home, for example). Other loans have soft prepayment penalties. You only will pay a penalty if you refinance the loan, but not if you sell your home. Some loans may have prepayment penalties even for partial prepayment.

Points

Discount points (also called discount fees) are points that the borrower voluntarily chooses to pay in return for a lower interest rate. One point is equal to 1 percent of the principal amount of a mortgage loan. For example, if the mortgage is $200,000, one point equals $2,000.

There are countless permutation of hooks and twists to mortgage offers and advertisements. No worries. As long as you’re able to extract all these basic bits of information out from under all the confusion, you’re well on your way to making a good decision.

Sources:

  1. Wikipedia: Adjustable Rate Mortgage

  2. Federal Reserve Bank of Boston: Know Before You Go… To Get a Mortgage

  3. Federal Housing Finance Agency (FHFA): Resources for Consumers

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