A Call To ARMs
By mortgage writer: Dave Leonhart
I writing this article to answer the many questions I receive regarding ARM loans and how they operate. If you’re interested in the details of ARM, this article should be right up your alley. If you’re only somewhat interested in ARMs, I would pass on this article and do something more interesting with your time.
Some Basics. Standard or Traditional ARMs:
First of all, the term ARM is an acronym “Adjustable Rate Mortgage.” Some lenders use the VRM which is the same thing as an ARM, but its acronym means “Variable Rate Mortgage.” Same thing… different term.
ARM loans have changed significantly over the years, and not all ARMs are the same… not even close! You can’t make a general statement like, “Is this ARM a good loan for me?” and expect one simple answer. Each ARM loan has its own unique characteristics and must be looked at individually.
Some people say they’ll never touch an ARM because you never know what can happen in the future with rates rising, which will cause their payments to rise too. And this is both true, and not true depending on the type of ARM you’re getting and how long you’ll be in the property.
I’ve made a simple guide for you to use to help you understand and decide whether or not an ARM loan is right for you.
An ARM in actuality is a short-term fixed rate loan. Generally speaking, the longer the term (number of years you’ll make monthly payments) the higher the interest rate. The reason is obvious… the longer the loan term, the greater the risk to the lender if interest rates were to rise significantly and you locked in a long term fixed rate loan. This is called “interest rate risk.” For example, if you had a 6% fixed rate for 30 years, and rates rose significantly after getting your loan to say, 8%. The lender is now losing money on the loan you have with them.
Now with ARMs, the same rules apply. A one year ARM will be a lesser interest rate than a five year ARM. (This assumes you are comparing an ARM that adjusts one year and five years respectively. Not ARMs that adjust every month or six months)
Lenders like offering you ARMs because it transfers the “interest rate risk” to the borrower and away from the lender. (For the most part)
Indexes
ARMs are “tied” to an underlining index. What this means is the interest rate your paying on an ARM is based on what the underlining index is doing. Indexes come in a variety of flavors, but they all work essentially the same way. The most indexes are the LIBOR (London Inter-Bank Offered Rate), the TCM (Treasury Constant Maturities) and the COFI (pronounced “coffee” which is the 11th District Cost of Funds) Whew! That’s a mouth full.
There are many other indexes that are based on deposit rates and other metrics, all of which are unique to each lender. To see a comparison of the various indexes click here for a chart.
There is no particular better index to have a loan tied to, but each lender will tend to espouse why their indexes are the best. I’ve personally found the 11th district Cost of Funds (COFI), and indexes tied to deposits to be some of the least volatile and slowest moving.
Starting Rates
The starting rate for ARMs can be very different depending on the ARM. Some ARMs have what is called a “teaser rate” which is generally very low, or considerably lower than most other loans. However, most ARMs starting rates are based on the “index” and a new item I’ll explain next called the “margin.”
Margin
A margin is a very important term to understand because the margin+index = is equal to the interest rate you’ll pay. For example, if your margin was 2% and the index was 3%, your interest rate will be 5% for the adjustment period. Now if interest rates rose suddenly, and the index rose to 4%, your new rate would be 6%. (4% index + 2% margin = 6%)
Generally, your margin will always remain the same throughout the loan’s term, but the index can change virtually everyday.
Depending on the type of ARM you get, and other factors such as your personal credit rating, will determine what your margin rate will be. They can range anywhere from the mid 1% to as high as 6% or more. (Approximately speaking, each lender is different)
Caps
Caps are designed t protect the consumer from “payment shock” if rates were to increase dramatically over a short period of time. In other words, if rates were to rise significantly the Cap puts a roof (a maximum amount per adjustment period) on the payment or interest rate, therefore reducing the amount your payment will increase upward.
And yes, just to make things even more confusing, there are several types of caps.
There are “payment caps,” which limit the amount the “payment” can change during any particular adjustment period. Now, this can be somewhat confusing, but if you have an ARM with a payment cap, you have a loan which can possibly go into negative territory. This means that if you make the minimum payment due you could be paying less interest than you should due to the “payment cap,” and this extra interest that is not being paid by you, is actually being added to the loan balance. Thus, you now have what is called a “Negative Amortization” loan or Neg-Am for short.
Most lenders who offer these types of loans will provide you the option on the monthly statement you’ll receive to increase your payment enough to eliminate the negative feature.
There are also interest “rate caps,” which are the more common type, and place a ceiling on the maximum an interest rate can increase during any particular adjustment period.
Now, note that both of the above caps are effective during the adjustment periods only. So, what cap stops (or caps) the adjusting periods, you say?
Well, this is the one is called the “life cap” which places a true maximum amount the interest rate (or payment) can increase over the life-of-the-loan.
Most ARMs have a maximum “rate cap” of 2% in any one adjustment period, and a maximum “life cap” of 6%. These are referred to 2/6 ARMs. So, the maximum your interest rate can increase is 6% over the life of the loan.
Hmm, so how comforting is that anyway? Would a 6% increase in your interest rate maybe change your mind about getting an ARM? Let’s find out, read on…
Maybe an example is appropriate here:
Let’s say you have 1-year ARM and 5% for the first year. Now, after a year has passed, the lender will revalue the ARM by adding the index of 4.50% (we making this up, remember) to a margin of 2.50%, which means your new interest rate will be 4.50 + 2.50 = 7%. But… since you have a 2% maximum “rate cap” at any one adjust period, the lender must lower the amount to 6.50% (4.50 + 2 = 6.50)
Therefore, your interest rate cannot increase more than 6.50% See that’s not so bad.
The lender simply loses out in this example for the additional interest they could have earned, but couldn’t due to the interest rate cap in place.
Adjustment Periods
An adjustment period is the time-period between each adjustment; here we have again a whole variety to choose from.
ARMs can adjust monthly, every three months, every six months, annually, or even every three, five, seven, or ten years.
Hybrid ARMs
The most popular ARM today is not a traditional ARM at all, as described above. It is called a hybrid-ARM because you have options for fixing the interest rate for 1, 3, 5, 7 & even 10 years, before they “convert” into a traditional ARM loan for the remainer of the loan.
So n theory, you could even call them fixed rates that convert into an ARM and you would be correct.
The fixed rate period is tied to an index like the traditional ARM, but rather set by market forces and lenders needs at the time. So when shopping for a Hybrid-ARM, rates can vary significantly since there is more leeway, I suppose you could say.
The Hybrid ARM is a very interesting alternative for many homeowners to ponder over since they offer the security of a fixed rate for a specific period of time. And if you “know” that you will only need the loan for a specified period, say five years, why get a 30-year fixed rate, right?
Remember, what I said above: the longer the term, the higher the interest rate. So, a 30-year loan will have a higher rate than a 5/1 hybrid-ARM; or, a 3/1 hybrid ARM will have a lesser rate than a 5/1 hybrid.
Did you notice that these hybrids-ARMs are called 3/1, 5/1, 7/1, etc? The numerator is term the loan is fixed, and the denominator simply means that once the term for the fixed period has expired, the ARM will then adjust annually thereafter.
Which ARM is right for you?
That’s a tough question to answer quickly, since there are so many ARMs available and each person has different needs. But, the easiest way is to match up your time frame of living in the home against the ARM’s term. If you’re buying a home and knowing that you’ll have to move in a couple years a 3/1 or at most 5/1 ARM is probably right for you.
However, if you are financially savvy and want the lowest possible payment so you can make investments elsewhere with the extra cash, maybe a standard monthly ARM with a low start rate is right for you.
Some more aggressive types like the lowest payment possible in order to maximize their home purchase, and if rates don’t go the way they want, they’ll simply refinance into a fixed loan. They figure that with the super-low start rates of some of these ARMs have, they’ll save enough money in interest, even if they have to refinance immediately thereafter.
Generally, I don’t recommend a standard ARM to anyone in a rising interest rate environment, and I also don’t recommend a hybrid-ARM if the borrower wishes to live in the house indefinitely, or even if they wish to stay in the home for more than 11 years. The reason is simple: the time period is just too long to risk it.
Here are some reasons why you should consider an ARM over a fixed rate:
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