Understanding Adjustable Rate Mortgages (ARM) in Today's Market

Introduction: Adjustable Rate Mortgages (ARMs) are a significant option in the housing market, offering varied risks and benefits. It's essential for potential homebuyers to grasp the structure of an ARM.

1. ARM Basics:

ARMs differ from fixed-rate mortgages as their interest rates change over time, typically linked to financial indices like the Prime Rate, the SOFR (Secured Overnight Financing Rate) replacing the phased-out LIBOR, the One-year Treasury bill, the 11th District cost of funds index (COFI), and a lender-determined margin. Initially, ARMs have a fixed-rate period, followed by periodic rate adjustments.

2. Initial Fixed-Rate Period:

This period varies from one to ten years, providing stability with usually lower rates than fixed-rate mortgages, appealing for short-term plans.

3. Adjustment Periods:

Post the fixed-rate phase, ARMs adjust at intervals outlined in the loan agreement, with rate caps to limit changes.

4. Rate Caps and Floors:

Caps prevent drastic rate increases, while floors set minimum rates.

5. Index and Margin:

Interest adjustments depend on a chosen index reflecting market conditions, plus a fixed margin. This combination sets the adjusted rate.

6. Advantages and Risks:

ARMs initially offer lower rates but pose risks with potential future rate increases.

7. Suitability:

Best for those planning short-term ownership or anticipating income growth.

Conclusion: ARMs balance benefits and risks. Understanding rate adjustment implications and personal financial planning is crucial. Seeking expert advice is recommended for tailored decision-making.

Previous article on same subject:

Anatomy of an Adjustable Rate (ARM) - Refinance Loan Programs
Adjustable Rate Mortgage

by Nancy Osborne, COO of ERATE®

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.

INDEX + MARGIN = FULLY INDEXED RATE

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%)

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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.

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Nancy Osborne, ERATE.com Nancy Osborne has had experience in the mortgage business for over 20 years and is a founder of both ERATE, where she is currently the COO and Progressive Capital Funding, where she served as President. She has held real estate licenses in several states and has received both the national Certified Mortgage Consultant and Certified Residential Mortgage Specialist designations. Ms. Osborne is also a primary contributing writer and content developer for ERATE.