Adjustable Rate Mortgage (ARM) - dummies

Adjustable Rate Mortgage (ARM)

By Eric Tyson, Robert S. Griswold

What is an adjustable rate mortgage? Adjustable-rate mortgages (ARMs) have an interest rate that varies over time. On a typical ARM, the interest rate adjusts every 6 or 12 months, but it may change as frequently as monthly. Popular ARMs include hybrid loans where the initial interest rate is locked in for the first three, five, seven, or ten years and then adjusts after that (see the sidebar “Fixed-rate periods on hybrid-ARMs”).

The interest rate on an ARM is primarily determined by what’s happening to interest rates in general. Remember that interest rates are the “price” for the commodity or product known as cash money. If the price of borrowing money is increasing, then most interest rates are on the rise. In this scenario, the odds are that your ARM will also experience increasing rates, thus increasing the size of your mortgage payment. Conversely, when interest rates fall (as the price of money becomes cheaper usually due to less demand and more capital available in the market), ARM interest rates and payments eventually follow suit.

If the interest rate on your mortgage fluctuates, so will your monthly payment sooner or later. And therein lies the risk: Because a mortgage payment is probably one of your biggest monthly expenses (if not the biggest), an adjustable-rate mortgage that’s adjusting upward can wreak havoc with your budget.

You may be attracted to an ARM or hybrid loan because it starts out at a lower interest rate than a fixed-rate loan and thus may enable you to qualify to borrow more. However, just because you can qualify to borrow more doesn’t mean you can afford to borrow that much, given your other financial goals and needs.

The right reason to consider an ARM is because you may save money on interest charges and you can afford the risk of higher payments if interest rates rise. Because you accept the risk of an increase in interest rates, mortgage lenders cut you a little slack. The initial interest rate (also known as the teaser rate) should be significantly less than the interest rate on a comparable fixed-rate loan. In fact, even with subsequent rate adjustments, an ARM’s interest rate for the first year or two of the loan is generally lower than a fixed-rate mortgage.

Another important advantage of an ARM is that, if you purchase your home during a time of high interest rates, you can start paying your mortgage with the artificially depressed initial interest rate. If overall interest rates then decline, you can capture the benefits of lower rates without refinancing as your ARM adjusts lower.

Here’s another situation when adjustable-rate loans have an advantage over their fixed-rate brethren: If, for whatever reason, you don’t qualify to refinance your mortgage when interest rates decline, you can still reap the advantage of lower rates. The good news for homeowners who can’t refinance and who have an ARM is that they’ll receive many of the benefits of the lower rates as their ARM’s interest rate and payments adjust downward with declining rates. With a fixed-rate loan, by contrast, you must refinance to realize the benefits of a decline in interest rates.

The downside to an adjustable-rate loan is that if interest rates in general rise, your loan’s interest and monthly payment will likely rise, too. During most time periods, if rates rise more than 1 to 2 percent and stay elevated, the adjustable-rate loan is likely to cost you more than a fixed-rate loan.

How an ARM’s interest rate is determined

Most ARMs start at an artificially low interest rate. Don’t select an ARM based on this rate because you’ll probably be paying this low rate for no more than 6 to 12 months, and perhaps for as little as 1 month. Like other salespeople, lenders promote the most attractive features of their product and ignore the negatives. The low starting rate on an ARM is what some lenders are most likely to tell you about because profit-hungry mortgage lenders know that inexperienced, financially constrained borrowers focus on this low advertised initial rate.

The starting rate on an ARM isn’t anywhere near as important as what the future interest rate is going to be on the loan. How the future interest rate on an ARM is determined is the most important issue for you to understand when evaluating an ARM — if you plan on holding onto your loan for more than a few months.

To establish what the interest rate on an ARM will be in the future, you need to know the loan’s index and margin, the two of which are added together.

So ignore, for now, an ARM’s starting rate and begin your evaluation of an ARM by understanding what index it is tied to and what margin it has.

What are the index and margin? So glad you asked!

Start with the index

The index on an ARM is a measure of general interest rate trends that the lender uses to determine changes in the mortgage’s interest rate. For example, the one-year Treasury constant maturity index is a common index used for many ARMs.

Suppose that the going rate on this index is approximately 2 percent. The indexes used on various ARMs theoretically indicates how much it costs the bank to take in money, for example, from people and companies investing in the bank’s various accounts, which the bank can then lend to you, the mortgage borrower.

The following sections explain the most common ARM indexes. Don’t worry about lenders playing games with the indexes to unfairly raise your ARM’s interest rate. Lenders don’t control any of the indexes discussed here. Furthermore, they’re easy to verify. If you want to check the figures, you can usually find these indexes in publications such as The Wall Street Journal for online sources for this information.

TREASURY SECURITIES

The U.S. federal government is the largest borrower in the world. So it should come as no surprise that some ARM indexes are based on the interest rate that the government pays on some of its pile of debt. The most commonly used government interest rate indexes for ARMs are for one, three, five, and ten-year Treasuries.

The Treasury security indexes are volatile; they tend to be among the faster-moving ones around. In other words, they respond quickly to market changes in interest rates. Treasury indexes are good when interest rates are falling and lousy when rates head higher.

THE LONDON INTERBANK OFFERED RATE INDEX (LIBOR)

The London Interbank Offered Rate Index (LIBOR) is an average of the interest rates that major international banks charge each other to borrow U.S. dollars in the London money market. Like the U.S. Treasury indexes, LIBOR tends to move and adjust quite rapidly to changes in interest rates.

This international interest-rate index became increasingly popular as more foreign investors bought American mortgages as investments. Not surprisingly, these investors like ARMs tied to an index that they understand and are familiar with.

Be sure to ask your lender how the index tied to the ARM you’re considering has changed in the last five to ten years.

Add the margin

The margin, or spread as it’s also known, on an ARM is the lenders’ profit, or markup, on the money that they lend. Most ARM loans have margins of around 2.5 percent, but the exact margin depends on the lender and the index that lender is using. When you compare several loans that are tied to the same index and are otherwise the same, the loan with the lowest margin is better (cheaper) for you.

All good things end sooner or later. After the initial interest rate period expires, an ARM’s future interest rate is determined, subject to the loan’s interest rate cap limitations,by adding together the loan’s current index value and the margin.

The following formula applies every time the ARM’s interest rate is adjusted:

For example, suppose that your loan is tied to the one-year Treasury security index, which is currently at 2.5 percent plus a margin of 2.25 percent. Thus, your loan’s interest rate is

This figure is known as the fully indexed rate. If a loan is advertised with an initial interest rate of, say, 3.5 percent, the fully indexed rate (in this case, 4.75 percent) tells you what interest rate this ARM would rise to if the market level of interest rates, as measured by the one-year Treasury security index, stays at the same level.

Always be sure to understand the fully indexed rate on an ARM you’re considering. To avoid any surprises, you also should know what the payment will be for various potentially higher interest rates during the life of your loan, including the maximum rate, so you fully understand what the maximum possible monthly payment is. Ask the lender and/or your mortgage broker to provide this payment information.

How often does the interest rate adjust?

Although some ARMs have an interest rate adjustment monthly, most adjust every 6 or 12 months, using the mortgage-rate determination formula discussed previously. In advance of each adjustment, the mortgage lender should mail you a notice, explaining how the new rate is calculated according to the agreed-upon terms of your ARM.

The less frequently your loan adjusts, the less financial risk you’re accepting. In exchange for taking less risk, the mortgage lender normally expects you to pay more — such as a higher initial interest rate and/or higher ongoing margin.