Adjustable Rate Mortgages (ARMs) first became popular in the early
1980's when interest rates were much higher and more volatile.
They are simply long term mortgages having periodic interest rate
adjustments which allows flexibility in the monthly loan payments.
ARMs are fully amortizing loans and can be structured to fit just about
any need or budget.
Some ARMs are negative amortizing in that the principal balance
of the loan can increase faster than the loan is being paid off through
monthly payments. Usually, these involve shorter term
loans carrying a balloon balance which will be paid in full at maturity
of the balloon.
Important features of ARMs are outlined below:
Index
Interest rates move in tangent with a short term interest rate
index usually published in the Wall Street Journal or other business
publication. Lenders may tie their interest rates on ARMs to
either a specific index such as the 1-year Treasury security
yield (based on a constant maturity,) LIBOR - London
Inter Bank Rate, or the 11th District Cost of Funds (COFI)
or their rates may be tied to a bundle or average of many interest
rates or indicators. The indexes usually move in
tangent with other debt instruments and
interest rate indicators.
Margin
A "margin" of an ARM is the interest rate "spread"
(expressed as a percentage) that is combined with the index
comprising the rate of interest charged on the ARM loan.
Margins remain fixed throughout the loan term and are not impacted
by interest rate movements in the financial markets. Lenders
use a variety of margins depending upon the loan product and rate
adjustment period.
Interest Rate
The interest rate is the combination of the index plus the
margin.
Adjustment Period
The adjustment period that designates when the interest rate will
be adjusted is outlined in the mortgage note and remains fixed
during the life of the loan. Adjustment periods can vary from
a month to 7 years although most ARMs adjust about every
6 months to 1 year.
Lenders are usually required to notify borrowers before payment
and interest rate changes occur.
Periodic Interest Rate Caps
ARMs usually have interest rate "caps" on the amount that
the rate may actually change. Generally, a mortgage
with a 6-month adjustment period has a cap of 1% while a
1- year ARM usually has a 2% cap.
Beware of any lenders that do not offer an interest rate cap but
only offer a cap on the payment adjustments. This type of ARM
loan has the potential of creating negative amortization.
Life Cap
The "life cap" is the maximum rate the loan may have over
it's life. Life caps vary by lender and/or investor
although most have caps of 5% to 6%.
Beware of "teaser rates" that a lender may offer as an
introductory rate that is below the fully indexed rate.
Convertible ARMS
Some lenders offer convertible ARMs, loans with a convertible
feature that allows the borrower to change from an adjustable rate
to a fixed rate at some point in the future.
Some ARMS are retained in the lenders' portfolio and can be an
appealing asset because the indexed rate can be structured to interest
rates paid on deposits. ARMs can also be sold in the secondary
market as a capital market debt instrument aggregated into mortgage
backed securities. The primary disadvantage to borrowers is the
potential of higher future rates.
Considering An ARM?
How long will I occupy my home? (If you plan to sell in the
next 3 or 4 years, ARMs may be a good option to consider.)
Is my income likely to rise if interest rates increase?
Can the monthly payments increase even if interest rates do
not?
Am I anticipating any major expenditures in the future
(college tuition or a new car) that will require more borrowing?
Note: When comparing ARMs, look closely at the index and margin and
discuss with the lender. Some indexes may have higher average values but
could be used with lower margins. Be sure to compare "like"
products.
