Adjustable Rate Mortgages
(ARMs)
Adjustable Rate Mortgages (ARMs) start out as though they were fixed
rate mortgages for a period of time, but then have periodic changes
in the interest rate which causes changes in your monthly
Principal and Interest payment. On the other hand, with fixed
rate mortgages the Interest
Rate and monthly Principal and Interest payment stay the same for the full term of the loan.
There are too many varieties of ARMs to describe all of them on
this page, but I hope to give you an overview, so you know which
questions to ask if you're considering an Adjustable
Rate Mortgage.
As on overview, my way of thinking is that a fixed rate mortgage shifts "Interest Rate
Risk" to the investor (mortgage company), whereas ARMs require you to
take on future "Interest Rate Risk." When you lock-in the
interest rate
on a fixed rate mortgage, you lock-in for the full term of the loan.
When you lock-in the interest rate on an ARM, you only lock in the rate until the
Initial Adjustment Date. Typically an ARM adjusting after the
first month would have the lowest initial rate. The longer you
stretch out that first adjustment date the higher the initial interest
rate is likely to be. If you want to stretch out the initial
adjustment period to10 years (10/1 ARM), the rate is typically close
to a 30 year fixed rate mortgage, negating any reason for doing an
ARM.
For ARMs the lock-in agreement is more complicated and an ARM
disclosure is also required. Both forms state the
initial interest rate, the initial adjustment period, subsequent
adjustment periods, initial adjustment cap, subsequent adjustment
caps, lifetime cap, interest rate floor, index and margin. As
you can already see, evaluating ARMs is a little more complicated then
evaluating fixed
rate mortgages.
The key to
understanding ARMs is understanding the terms used to describe their
parameters.
Following are some general definitions often used to describe ARMs:
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Initial interest rate -
The rate used to calculate
your payment when you go to closing. It is not the Annual
Percentage Rate. It is the interest rate you lock in for the
initial adjustment period. |
|
Initial adjustment period -
The length of time
before the first interest rate adjustment. It can be as short
one month or as long as ten years. For a one year ARM this
period would be one year and for a 5/1 ARM this period would be
five years. |
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Subsequent adjustment period - The
length of time for adjustments after the initial adjustment
period. One, six and twelve month increments are the most
common. A 5/1 ARM has a subsequent adjustment period of one
year. After the first five years it will adjust once each year
thereafter. |
|
Initial adjustment cap -
The
maximum interest rate change (up or down) that will occur at the
first adjustment date. Some ARMs have no adjustment caps. Some
ARMs have an initial adjustment cap that is different then the
subsequent adjustment caps. |
|
Subsequent adjustment cap -
The
maximum interest rate change at each adjustment date after the
first adjustment. Some ARMs have no subsequent adjustment caps. |
|
Life time adjustment cap -
The highest rate the mortgage will incur under any
circumstances. It may be stated as a percentage above the
initial rate, for example 6% above the initial rate, or as a
specific percentage rate such as 11.5%. Some ARMs have life
time caps as high as 22%, or more, or have no caps at all. |
|
Interest rate floor -
The lowest rate that will be charged under any circumstances. |
|
Index -
The
guide (or economic barometer) used on each adjustment date.
There are several common Indexes used. They include Prime Rate,
One Year Constant Maturity Treasury Index, London Interbank
Offered Rate, 11th District Cost Of Funds Index and
12 Month Treasury Average. Each index reflects a part of the
economy that changes from time to time. For example the One
Year Constant Maturity Treasury Index reflects the interest rate
the US Government pays to borrow money for one year and varies
with economic conditions. With this type of ARM, your rate
would vary in tandem with the rate the US Government pays to
borrow money for one year, but you would pay rate adjusted
upward by your margin. |
|
Margin - When
your rate is adjusted, this is the amount above the Index that
your interest rate will be adjusted to. |
|
Monthly Payment Cap
– When there is a limit on the amount the monthly payment
will increase regardless of the changes in interest rate.
|
|
Negative amortization potential -
This is when your
principal balance may increase instead of decrease as time
passes. It is a “byproduct” of a Monthly Payment Cap. |
Typical adjustment calculation
- At each adjustment date the interest rate typically changes based
on the sum of the index and margin. For example if the index is
1.75% and the margin is 2.25%, the sum is 4.00% and that will be the
newly adjusted rate for the next period of time, so long as the
proposed adjustment doesn't exceed the periodic adjustment cap, the
life time cap or the interest rate floor.
Index 1.75 (This value changes with
economic conditions)
Plus the Margin 2.25 (This value typically
remains constant for the full term of the loan)
Rate for the next period 4.00 (As long as none of
the caps have been exceeded)
Examples
of ARMS:
-
1/1 ARM The rate is fixed for
the first year and then adjusts annually after that.
-
3/1 ARM The rate is fixed for
the first three years and then adjusts annually after that.
-
5/1 ARM The rate is fixed for
the first five years and then adjusts annually after that.
-
A one month ARM is fixed for
one month and then adjusts monthly after that.
Examples
of Caps:
-
2/2/5 caps on a 5/1 ARM would
typically mean a first change date adjustment limit of 2%,
subsequent adjustment limits of 2% each adjustment date and a
lifetime cap of 5% above the initial rate.
-
5/2/5 caps on a 5/1 ARM would
typically mean an initial adjustment of limit of 5%, subsequent
adjustment limits of 2% each adjustment date and a lifetime cap
of 5% above the initial rate.
History and examples of ARM indexes: (Specific definitions may vary from one ARM
program to the next, so be sure you understand the ARM disclosure,
note and mortgage for the program you are considering)
- Prime Rate - The base rate on corporate loans
posted by at least 75% of the nation's 30 largest banks.
- CMT (1 Year Constant Maturity Treasury Index) The 1-Year
CMT is the weekly average yield on United States Treasury Securities
adjusted to a constant maturity of one year. (also referred to
as One year Treasury Constant Maturities)
- LIBOR - The average of London Interbank
Offered Rate for six
month US dollar-denomination deposits in the London Market (LIBOR),
as published in The Wall Street Journal.
- COFI - The 11th District Monthly Weighted Average Cost
of
Funds Index (COFI). The monthly COFI reflects the actual interest
expenses recognized during a given month by all savings institution
members of the Federal Home Loan Bank of San Francisco.
- 12 MTA (12 Month Treasury Average) The 12 month moving
average of annual yields on actively traded United States Treasury
Securities adjusted to a constant maturity of one year, as made
available by the Federal Reserve.
Examples of ARM disclosures:
- Consumer Handbook on Adjustable Rate Mortgages
- One year
ARM
- 5/1 ARM
- Six
month LIBOR ARM
NOTICE: The definitions and other information on this page are
only intended to give you an overview. The actual terms and definitions for
each ARM program may vary and are described in the initial ARM program
disclosure, Note and Mortgage. Nothing on this page is intended to
replace the intended legal definitions in those documents. When it comes to ARMs,
there is a lot of room for misunderstandings. If you do not
understand the ARM disclosure, note and mortgage for the program you're
obtaining be sure to seek competent advice.
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