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Adjustable Rate Mortgages

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Glossary of Terms

Adjustable rate mortgages become more popular as interest rates rise, and for good reasonthey make sense. They are, however, not without an element of risk.

When interest rates are low... 

  • The spread between adjustable rate and fixed-rate mortgages is small.
  • The likelihood of the adjustable rate increasing is relatively high.
  • Most borrowers prefer the safety and value of a fixed-rate loan.

When interest rates increase 

  • The spread between adjustable rate and fixed-rate mortgages is greater.
  • The likelihood of the adjustable rate increasing is diminished, and the likelihood of a lower rate improves
  • The advantages of an adjustable rate become more desirable

Types of ARMs
Many borrowers think of adjustable rate loans as the traditional 1/1, where the initial rate is guaranteed for only a year, and the rate adjusts each year thereafter. While the 1/1 options typically provides the lowest first-year rate, its higher volatility must be carefully considered.

There is a wide variety of adjustable rate mortgages (ARMs). For example, a 1/1 ARM means the initial rate is guaranteed for one year, and the rate adjusts every year thereafter. You may prefer to choose a 3/1 ARM, where the initial rate is guaranteed for 3 years, then adjusts every year thereafter. Depending on the loan you choose, you may be able to select from the following menu: 1/1, 3/1, 5/1, 7/1, 10/1. All these loans are typically based on a 30-year amortization.

Index and Margin
The rate adjustments are based on two factors: the INDEX and the MARGIN. Many ARM products are based on the weekly average yield of the US Treasury Securities, adjusted to a constant one-year maturity (the index), plus the margin. Some ARMs have a different index.

For example, suppose a borrower has a 3/1 ARM based on the weekly average of US Treasury Securities and a margin of 2.75%. Beginning with the fourth year, the interest rate will adjust. If the US Treasury Index is at 5.50% and the margin is 2.75%, the new interest rate will be 8.25% (5.50+2.75=8.25). Each year thereafter the rate will adjust based on the US Treasury.

Remember, the initial rate of an ARM is usually lower than the current "index + margin" rate. Thus, with no change in the underlying index rate, the first adjustment will likely be upward. However, if interest rates decline, there may be a rate decrease.

Rate Caps
Borrowers aren't completely unprotected during the rate adjustments. Each ARM has a number of limitations on rate adjustments.

Lifetime Cap: The maximum increase the interest rate can adjust over the life (term) of the loan. For example, if the initial rate is 7.5% and the lifetime cap is 6%, the rate may never climb above 13.5%.

First Adjustment Cap: The maximum increase that can take place on the first adjustment made to the interest rate of the loan. For a 3/1 ARM, this adjustment is made at the beginning of the fourth year. It may be as low as 1% or as high as the lifetime cap (typically 6%). Be sure your lender tells you this information.

Adjustment Cap: Following the first adjustment, this is the maximum the rate can increase or decrease at each subsequent adjustment of the loan. Usually the adjustment caps are 2% on conventional loans and 1% on FHA loans.

Floor: This is the lowest the rate can go, and it varies with the ARM product.

Many adjustable rate loans have a convertibility feature, allowing the borrower to convert the adjustable rate to a fixed-rate for the remainder of the loan term. Terms for the convertibility vary among ARMs, but many are based on the current FNMA yield plus a small margin. Others are based on the current rate of the ARM. The specific windows of opportunity when the loan can be converted vary with the variety of ARM products. Although there is usually a fee associated with the conversion, it's far less than the cost of a new loan and no re-qualification is required. ARMs with a convertibility feature often cost slightly more than ARMs without the convertibility feature.

Prepayment Penalty
Some ARMs may have a prepayment penalty in exchange for a lower rate. The penalty is usually eliminated after 3 to 5 years, but varies among ARM products. If you're confident you'll keep the loan longer than the prepayment penalty applies, the advantages of the lower rate may make sense for you. Be sure you know if your loan has a prepayment penalty.

Why Choose an ARM?
There are a number of reasons to choose an ARM. Your best source of information is your Loan Originator, but a brief summary follows:

Advantages of an ARM

  • It usually increases the level of borrower qualification (you can afford more home).
  • It provides a lower initial rate. Works well for people who expect an increase in income.
  • It provides a lower rate than a fixed-rate loan. If interest rates decline, the rate will improve (while those who chose a higher, fixed-rate at the higher rate.) An ARM makes sense if the borrower believes interest rates will remain stable or decline by the time the initial ARM rate expires. An ARM also makes sense for borrowers who believe they will move (sell the property) before the initial rate expires. Finally, an ARM makes sense for those who want a lower rate now, and who plan to convert to a fixed-rate or refinance when the rates decline.
  • A little-understood feature of an ARM is the procedure for calculating payments. Each time the rate is adjusted, the loan is re-amortized over the remaining term of the loan. For those who plan to make a substantial "bulk" contribution to the principal balance in the future, the result is different than with a fixed-rate loan. For example, suppose one borrower has a fixed-rate loan for $100,000 and another borrower has an ARM for $100,000. Both borrowers inherit $25,000 and want to pre-pay the loan. The fixed-rate borrower will not see a difference in the monthly payment, but will have the loan term shortened considerably. The ARM borrower will see a substantial reduction in the payment at the next adjustment, but the term of the loan remains the same.

An Adjustable Rate Mortgage makes sense for many people when interest rates are relatively high. Discuss your objectives and needs with a Loan Originator to determine if an ARM can save you money.

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