Many ARM loans are based on the LIBOR index (London Interbank Offered Rate), which currently stands at 0.58%. If you Google “LIBOR interest rate adjustment chart” you can find your own results to see how LIBOR has adjusted over time, or go to a chart of historical LIBOR rates by clicking here.

Just four years ago in January 2009 the LIBOR rate stood at 1.9%, January 2008 it was 3.4%, and January of 2007 was 5.4%! Using the LIBOR index as an example, we can hypothesize how the rate adjustments may happen on ARM loans. Many LIBOR ARM loans adjust using a predetermined number, called a margin, somewhere between 2.50% to 2.875%, added on top of the LIBOR index. So the formula is:

LIBOR + Margin = New Rate (however the new rate must conform to the 2% annual cap).

Let’s assume LIBOR is currently at 0.50% (it’s currently 0.58%), and that the margin is 2.50% (which is on the low end of the range), and that the annual cap is 2% (which is standard). Further, let’s assume your current rate is 3%. Last, let’s assume you can refinance to a current 30-Year fixed rate at 4.625%.

Looking at the aforementioned LIBOR chart, history shows LIBOR can move up and down in 1% to as much as 4% increments year over year. Of course, LIBOR can also stay flat. For this hypothetical example we are assuming a rising interest rate market, and considering a refinance to avoid possible future rate increases. If LIBOR jumps only 1% a year for the next three years, you’d find your rate adjustment as follows:

January 2014 0.58% LIBOR

January 2015 1.50% LIBOR

January 2016 2.50% LIBOR

January 2017 3.50% LIBOR

Again, considering the history of LIBOR, these are not drastic assumptions. Below are the rate adjustments using the above LIBOR assumptions:

2015 = 1.50% + 2.50% =4.00%. With a current rate of 3% from 2014 and a cap of 2%, your new rate would be 4.00%.

2016 = 2.50% + 2.50% =5.00%. With a current rate of 4% from 2015 and a cap of 2%, your new rate would be 5.00%.

2017 = 3.50% + 2.50% =6.00%. With a current rate of 5% and a cap of 2%, your new rate would be 6.00%.

In 2014 you are pretty happy. In 2015 you are still below the current rate of 4.625%, not bad. In 2016 you are starting to feel some pain, and in 2017 you are miserable. This was assuming very moderate rate increases, but we can realistically see 2%, or even 3% and 4% rate increases. Let’s use some higher increases, and see if we should consider “buying insurance” (i.e. refinancing) against future rate increases:

January 2014 0.58% LIBOR

January 2015 2.50% LIBOR

January 2016 3.50% LIBOR

January 2017 6.50% LIBOR

Below are the rate adjustments based on these higher rate increases:

2015 = 2.50% + 2.50% =5.00%. With a current rate of 3% from 2014 and a cap of 2%, your new rate would be 5.00%.

2016 = 3.50% + 2.50% =6.00%. With a current rate of 5% from 2015 and a cap of 2%, your new rate would be 6.00%.

2017 = 6.50% + 2.50% =9.00%. With a current rate of 6% and a cap of 2%, your new rate would be 8.00%.

So the bottom line is that if you have an ARM loan, while you may have missed the bottom of the rate cycle, don’t forgo refinancing to a current fixed rate and take the risk of your ARM adjusting upwards to very uncomfortable levels!

Brian Martucci is a loan officer for Capital Bank Home Loans, a division of Capital Bank, N.A. He has been in the mortgage industry since 1986 and has served in a number of roles, including loan processor, loan officer, mortgage broker, branch manager, and vice president. Brian Martucci – NMLS# 185421. His opinions do not necessarily reflect the opinions and beliefs of Capital Bank Home Loans or Capital Bank. Capital Bank, N.A.- NMLS# 401599. Click here for the Capital Bank, N.A. “Privacy Policy”.

August 2nd, 2015 – I have an ARM based on the 6 month USD Libor with a life time cap of 13% no other cap. The margin is 2.25%. I would like to keep the house another 5 years before retiring. Do you think it is worth refinancing? I know rates are going to rise but how fast do you think? Thank you!

That is hard to say, I think I’d refi just for an insurance policy to protect against a big increase in rates. Rates have been so low for so long, we’ve all forgotten what “normal” rates are. I found this 220 year chart on Barry Ritholz’s website. Barry Ritholz is a seasoned asset manager. It can be seen on his website by clicking here: http://www.ritholtz.com/blog/2012/01/222-years-of-long-term-interest-rates/

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It is fascinating to me to see long term data like this, to put today’s financial numbers into perspective. It seems to me the average interest rate level in this country is about 6.5%, which is a long way from where we are now. Interest rates were in the mid 6’s around 1789 when the US Constitution was ratified! So it helps put into perspective what can happen when rates get back to normal, which everyone seems to think will be happening sooner rather than later.