ARM Loans

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How an Adjustable Rate Loan Works

To determine the rate on your adjustable mortgage, you first need to understand how an ARM works.

The following terms are integral to an ARM:

Fully Indexed rate - the rate you must pay, barring any periodic caps, in order to fully amortize or pay off the loan.

Margin - the fixed component of your ARM loan, constant throughout the life of the loan.

Index - the variable component of your ARM loan, changes on a monthly basis. Examples of indices include the Cost of Funds (11th District), One Year Treasury, Monthly Treasury Average (MTA), 1 Year Treasury Average, CD, LIBOR, etc.

Example using the 1 Year Treasury: 1 Year Treasury Index = 6.170 Loan Margin = 2.50 6.170 (Index) + 2.50 (Margin) = 8.67%** (Fully Indexed Rate) **(most lenders will round the rate to the nearest 1/8% so the actual rate would be 8.625%)

You should be familiar with the following ARM terms:

Teaser Rate - (aka your loan's start rate) the initial rate on your adjustable, prior to its first adjustment date, typically 6 months to a year.

Lifetime Cap - the maximum rate that your adjustable may climb to.

Floor Rate - the minimum rate that your adjustable may fall to.

Periodic Caps - the maximum percentage that either your rate or payment may change in any given year or specified time period. (See Interest Rate Cap and Payment Cap).

Interest Rate Cap - a periodic cap describing the maximum percentage that your rate may change in any given year or specified time period. Interest capped ARM's typically do not have negative amortization.

Payment Cap - a periodic cap describing the maximum percentage that your payment may change in any given year or specified time period. Applies to ARM loans with the potential for negative amortization.

Rate Change at the First Adjustment Date - usually applies to intermediate ARMs and can exceed the annual or semi-annual caps. Ask what it is.

Negative Amortization - occurs when the effective interest rate associated with a payment cap on an ARM is less than the fully indexed rate. In other words, the minimum payment allowed by the lender is less than the actual payment that is due. This difference or spread is then added onto the borrowers loan balance and rather than amortizing or paying down the loan balance, the loan balance actually grows.

When rates are on the rise many homeowners decide that they would rather have a fixed rate mortgage. The dilemma they find is that the fixed rate they wish to refinance into is also going up. If you have an intermdiate ARM that is in its initial fixed period you may want to refinance out of it before the first adjustment. Be sure to find out how much your rate can go up at the first adjustment. Some loans have a max adjustment of 2% while some go up by as much as 5%.

Should You Consider an Adjustable
Rate Mortgage

As its name implies, an adjustable rate mortgage (ARM) is one in which the rate changes (adjusts) on a specified schedule after an initial “fixed” period.

An ARM is considered riskier than a fixed rate mortgage because your payment may change significantly. In exchange for taking this risk, you are rewarded with an initial rate that is significantly below market rates for 30-Year Fixed Rate Mortgages. The more frequent the rate adjustments through the life of the loan, the lower the initial rate. Even after the loan adjusts, new rates will typically be below rates being offered to new borrowers for the 30-Year Fixed Rate program. Obviously, it’s best to have an ARM when interest rates are predicted to fall (not rise) because in periods of rising interest rates, it is possible that you will ultimately pay much more for an ARM than for a 30-Year Fixed Rate Mortgage.

Although somewhat riskier than a fixed rate mortgage, an ARM may benefit you if you have certain needs or find yourself in certain circumstances. In other circumstances, you may be better off with a fixed rate or other type of mortgage. Examine your financial and life situation with the help of your loan officer or financial advisor.

An ARM can give a short-term “boost” to your finances

Having a low initial fixed rate can free up some money early in your loan term.

For the purpose of illustration, we’ll assume a one-year ARM. This is a 30-year loan in which the rate (and therefore your monthly payment) changes every 12 months on the anniversary of your loan.

We’ll assume a 30-year fixed rate with zero points and a rate of 7.625 percent compared to a one-year ARM with zero points and an initial rate of 5.625 percent.

On a $240,000 loan amount, the 30-year fixed rate would yield a monthly payment of $1,698.70. The one-year ARM would yield a monthly payment of $1,381.58. That's a difference of $317 per month, or $3,800 over the next year.

What could you do with an extra $3,800 this year? Some borrowers find the extra money useful for paying off other credit or moving expenses, for landscaping the yard, and so on. Of course, you will want to stay away from incurring additional debt or improving your lifestyle to the point that you can’t afford the higher payment once your rate adjusts upward.

An ARM can allow you to qualify for "more house"

Obtaining an ARM can allow you to qualify for a higher loan amount and therefore a more valuable house.

Many people with exceptionally large mortgages get one-year ARMs and refinance them every year. The low rate allows them to buy a costlier home yet pay the lowest mortgage payment possible. The down side is that there are costs associated with refinancing. So before you use this option, look at all the costs and do the math yourself or ask for help from your loan officer.

An ARM could be beneficial depending on your future plans

What are the factors that could cause you to move or upgrade in the next few years? Why obtain a higher-rate 30-year fixed rate mortgage if a job transfer or twins is even close to likely? An ARM with a lower initial rate could be a better (and cheaper) way to go.

If you know that you are only planning on living in a property for a short period of time (1-10 years) then the benefits of getting an adjustable rate mortgage are enhanced. You can enjoy the interest and payment benefits with less of the risk. Ask your lender to help you crunch the numbers.

If you do plan to refinance or sell soon (and therefore pay off the loan), read the loan documents carefully. Some contracts stipulate a penalty for paying off the loan early.

What affects the amount of the adjustment?

The amount of the rate change (referred to as an Adjustment) is determined by a mathematical formula based on a particular index, the most common being the 1-Year U.S. Treasury Bill.

Your lender does not control the index so it is safe to assume that your adjustment will be fairly determined (although you should always verify your new rate by comparing with published numbers).

All adjustable rate mortgages have a lifetime rate cap (ceiling), which limits the amount the interest rate of the loan can increase over the life of your loan. Most adjustable rate mortgages also have a periodic rate cap, which limits the amount of rate increase for each adjustment.

What kinds of ARMs are available?

1-Year Adjustable Rate Mortgage
This is a 30-year loan in which the rate (and therefore your monthly payment) changes every 12 months on the anniversary of your loan. This loan is considered quite risky because your payment may change significantly from year to year.

3-Year Adjustable Rate Mortgage
This is a 30-year loan in which the rate (and therefore your monthly payment) changes every 3 years. This loan, while risky, is safer than the 1-Year Adjustable Rate Mortgage only because it does not adjust as frequently.

5-Year Adjustable Rate Mortgage
This is a 30-year loan in which the rate (and therefore your monthly payment) changes every 5 years. This loan is a nice compromise between shorter term Adjustable Rate Mortgages and Fixed Rate programs.

3/1 Adjustable Rate Mortgage
This 30-year loan offers a fixed interest rate for the first 3 years and then turns into a 1 Year Adjustable Rate Mortgage for the remaining 27 years of the loan.

5/1 Adjustable Rate Mortgage
This 30-year loan offers a fixed interest rate for the first 5 years and then turns into a 1 Year Adjustable Rate Mortgage for the remaining 25 years of the loan.

7/1 Adjustable Rate Mortgage
This 30-year loan offers a fixed interest rate for the first 7 years and then turns into a 1 Year Adjustable Rate Mortgage for the remaining 23 years of the loan.

10/1 Adjustable Rate Mortgage
This 30-year loan offers a fixed interest rate for the first 10 years and then turns into a 1-Year Adjustable Rate Mortgage for the remaining 20 years of the loan.