Adjustable Rate Mortgages

I am guessing that if rates climb, as many people expect has to happen at some point (although the way things have been going, who knows!), that Adjustable Rate Mortgages (ARM) will become more and more popular. Hence, a discussion of how ARMs work and what their parameters are is a good idea. And many people have a fear of ARM loans, but ARMs can you be your friend. They can be controlled, they can help you, love you, and save you money. They can also bite, hard. To start, knowing the different terminology is important.

Index

The index is what the lender will use to base your adjustments off of. A 1-year Treasury ARM will adjust based on whatever the 1-year Treasury Bill is. A 1 Year LIBOR ARM is one that will adjust based on what LIBOR is. If you really want to bore yourself, LIBOR stands for the London Interbank Offered Rate. It is a rate based on the interest rates at which banks borrow unsecured funds from other banks in the London wholesale money market. Zzzzzzzzz, do I hear sleeping? Crickets? I know, boring. I told you. But it is important, however, to note that LIBOR is a more stable index than the 1 Year Treasury bill.

Margin

Margin is the amount you add on top of the index to come up with the rate your ARM will change to after each adjustment. This number is an arbitrary, predetermined, fixed number, usually from 2.25% to 2.75%.

Fully indexed rate

This is the rate the lender calculates for your ARM by adding its margin to the index. However, there are usually caps put in place, so the lender does not get to “fully index” the rate each adjustment sometimes.

Caps

These are the ceilings and floors put in place for your ARM that cap how much the interest rate can change in a given time period. ARM loans will have an annual adjustment cap, and a lifetime cap which limits the total allowable change over the life of the loan.

Prepayment penalty

Many people fear the words “prepayment penalty”. But most prepayment penalties I see are common sense protections for the lender, and not to be feared. A common prepayment penalty is a “1 year prepayment penalty”. This means that if you payoff the loan within the 1st year there will be a penalty of some amount, for example 1% of the unpaid balance.

The lenders figure they are giving you a subsidized interest rate below what a fixed rate is. If you payoff it off quickly which takes away their ability to collect the interest payments and earn revenue, they’ll have to get revenue through the prepayment penalty. I think the fear of prepayment penalties has stemmed from a sleazy lack of disclosure of them in the past. There have also been stiff prepayment penalties lasting for many years, in the old days. But today, if a prepayment penalty exists, it usually only lasts one year. And it’s only to ensure the lender recaptures some revenue if the loan gets paid off unexpectedly quickly.

And there are “hard” and “soft” prepayment penalties. Soft prepayment terms allow you to prepay without penalty if you sell the home. Hard prepayment terms do not allow any exceptions, and there will be a penalty within the prescribed time period no matter what the reason for prepayment. Most prepayment penalties I see are the soft version, which are even more harmless.

Examples

1. Example #1: if there is a 1 year soft prepayment penalty, and you sell the home and payoff the loan within the first year of the loan, there is no penalty.
2. Example #2: if there is a 1-year hard prepayment penalty, and you sell the home within the first year of the loan, there is a penalty.
3. Example #3: if there is a 1 year soft or hard prepayment penalty, and you sell the home after the first year of the loan, there is no penalty.

Real Life Scenarios

Below are some scenarios to give you a better idea of how an ARM may adjust in real life.

Example #1:

5/1 Year LIBOR ARM, 2/6 caps, 2.5% margin, start rate 4%.
This means the rate is fixed for the first 5 years with no adjustments during that time.
Then at the start of year 6, it becomes a 1-year ARM and adjusts annually.
Caps are 2% per year, and 6% over the life of the loan.
Hypothetical LIBOR rate at start of year 6 = 2%.
Adjustment for year 6 = 2% + 2.50% = 4.50%.
Start rate was 4%, so the rate only goes up .5%.

Or take the same scenario with a different LIBOR rate:
Hypothetical LIBOR rate at start of year 6 = 7%.
Adjustment for year 6 = 7% + 2.50% = 9.50%.
Start rate was 4%, cap is 2%, so the rate only goes to 6%, it is “capped out”, and will not go to 9.50%.

Example #2:

5/1 Year LIBOR ARM, 5/2/5 caps, 2.5% margin, start rate 4% (this is the same example as in #1, except the caps are different).
The rate is still fixed for the first 5 years with no adjustments.
At the start of year 6, it still becomes a 1-year ARM.
Caps are 5% for the first adjustment, 2% per year, and a 5% lifetime cap.
Hypothetical LIBOR rate at start of year 6 = 7%.
Adjustment for year 6 = 7% + 2.50% = 9.50%.
Start rate was 4%, plus a 5% 1st adjustment, so the new rate is 9%. The rate goes up by 5% to 9%, it caps out, and does not go to 9.5%.
Some lenders on longer term ARMs, like 5, 7 and 10 year ARMs, have these 5/2/5 caps because they feel they have been covering your rate risk for such a long, fixed period of time; that they now deserve to “fully index” you and bring your rate up to market. Then you’ll have your 2/5 caps, which is 2% per year, and 5% lifetime, after that first potential big adjustment.

Example #3:

3/1 Year 1-Year Treasury ARM, 2/6 caps, 2.75% margin, start rate 3%.
This means the rate is fixed for the first 3 years with no adjustments during that time.
Then at the start of year 4, it becomes a 1-year ARM and adjusts annually.
Caps are 2% per year, and 6% over the life of the loan.
Hypothetical 1-Year Treasury rate at start of year 4 = 6.5%.
Adjustment for year 4 = 6.50% + 2.75% = 9.25%.
Start rate was 3%, so the rate only goes up to 5% thanks to the 2% per year cap.

Example #4:

3/1 Year 1-Year Treasury ARM, 2/6 caps, 2.75% margin, start rate 5%.
Hypothetical 1-Year Treasury rate at start of year 4 = 1.75%.
Adjustment for year 4 = 1.75% + 2.75% = 4.50%.
Start rate was 5%, so the rate goes down to 4.50%. Yes, rates go up and down.

Although ARMs may adjust down, most people think rates are at a historical bottom, and that rates in general may be rising. I wrote a great blog showing a 220 year history of interest rates here, that is pertinent reading.

That is the long and short of ARM loans. If you have an idea that you may only be in your home for a certain period of time, then trying to match that period of time with an ARM loan to cover it may be a brilliant idea. And if the government privatizes the mortgage industry and Fannie Mae and Freddie Mac go away, then we may not even have fixed rate mortgages anymore, which is the case in many other countries. So learning about ARM loans may be useful for several reasons.

Mortgage guidelines can change at any time, so always talk to an experienced mortgage loan officer who will help you understand the current guidelines and how they might apply to you.