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!