Borrower Guide to Adjustable Rate Mortgages

September 29, 2001 Most borrowers who take adjustable rate mortgages (ARMs) need them to qualify for the loan they want. Because the initial rate on ARMs is usually lower than the rate on fixed rate mortgages (FRMs), these borrowers can qualify with an ARM but not with a fixed-rate mortgage (FRM). When interest rates rise, fewer borrowers can qualify using FRMs, with the result that ARMs increase in relative importance. Some borrowers are pushed into ARMs on the grounds that they need an ARM to qualify, when in fact they don't. This is discussed in Do I Really Need an ARM to Qualify? But there are other borrowers for whom ARMs make economic sense who avoid them because they don�t understand them. They are the focus of this article, which attempts to take the mystery out of ARMs by explaining how they work. The Initial Fixed Rate Phase There are two phases in the life of an ARM. During the first phase, the rate is fixed, just as it is on an FRM. The difference is that on an FRM the rate is fixed for the term of the loan, whereas on an ARM it is fixed for only a limited period at the beginning. At the end of that period, the rate probably will increase. The initial period of rate stability lasts from one month on a one-month ARM to 10 years on a 10-year ARM. Borrowers choose ARMs mainly for the lower rate at the beginning. In general, the lower the initial rate on an ARM, the shorter the fixed-rate period. In a market in which the 30-year FRM rate is 8%, for example, the initial rate could be 5% on one-month ARMs, 7% on one-year ARMs, and 7.75% on 10-year ARMs. Determining the Rate After the Initial Rate Period Ends Subject to two possible exceptions, the rate on the ARM after the initial rate period ends equals the most recent value of a specified interest rate index, plus a margin. The index plus margin is the "fully indexed rate." There are a variety of interest rate indexes used with ARMs, and it is necessary to determine exactly which index is used on a particular ARM, and to determine its most recent value. This information is available in many newspapers and on a number of web sites. The margin, usually 2.50 to 3.0%, is stipulated in the ARM contract. Thus, if the most recent value of the index when the initial rate period ends is 5% and the margin is 2.75%, the new rate will be 7.75%, provided that this rate does not violate either of the two exceptions. The first exception is that the increase from the previous rate cannot exceed the rate adjustment cap, which imposes a limit on the size of any interest rate increase. In most cases, rate  adjustment caps are 1% or 2%, depending on the frequency of rate adjustments. However, on ARMs where the initial rate holds for 5, 7 or 10 years and then adjusts annually, the cap at the first rate adjustment is usually 5%, dropping to 2% on subsequent (annual) adjustments. The second exception is that the new rate cannot exceed the maximum allowable rate on the ARM contract. A maximum rate will usually be about 5 or 6 percentage points above the initial rate. Most ARMs contain both rate  adjustment caps and maximums; some have one but not the other; a few have neither but have payment adjustment caps instead (see below). Assuming the fully indexed rate at the first rate adjustment is above the initial rate, the rule for determining the new rate is the following: the new rate is the lowest of a) the fully indexed rate, b) the initial rate plus the rate adjustment cap, and c) the maximum allowable rate. To illustrate the rule, 3 examples are shown below. In the first, the new rate is the fully indexed rate because the fully indexed rate is less than the initial rate plus the adjustment cap and less than the maximum rate. In the next, the new rate is the initial rate plus the adjustment cap because this is lower than the fully indexed rate or the maximum rate. In the last case, which would be highly unusual, the new rate is the maximum rate because that rate is less than the fully indexed rate or the initial rate plus the adjustment cap.   Initial Rate Fully Indexed Rate at First Rate Adjustment Adjustment Cap Maximum Rate New Rate 6.00% 7.75% 2.00% 11.00% 7.75% 5.00 7.75 2.00 10.00 7.00 4.00 10.00 None 9.00 9.00 Assuming the fully indexed rate at the first rate adjustment is below the initial rate, the rule for determining the new rate is the following: the new rate is the higher of a) the fully indexed rate, b) the initial rate less the rate adjustment cap, and c) the minimum allowable rate. Initial Rate Fully Indexed Rate at First Rate Adjustment Adjustment Cap Minimum Rate New Rate 6.00% 5.00% 2.00% 4.00% 5.00% 6.25 4.00 1.00 4.00 5.25 5.00 4.00 2.00 4.50 4.50 In case one, the new rate is the fully indexed rate, in case two it is the initial rate less the rate adjustment cap, and in case three it is the minimum rate. Why Rates Usually Rise on the First Rate Adjustment A critically important number for the consumer to have in making a decision about an ARM is the current fully indexed rate. This is the most recent value of the rate index plus the margin. This number tells the consumer what will happen to the rate if interest rates do not change from the levels prevailing at the time the loan is taken out. If the initial rate is below the current fully indexed rate, as is the case on virtually all ARMs, the rate will increase if the index value doesn't change. Subsequent Rate Adjustments The period until the second rate adjustment need not be, and frequently is not the same as the initial rate period. For example, ARMs on which the initial rate is set for 5 years usually adjust every year thereafter. This type of loan is often designated a 5Y/1Y, the first figure denoting the length of the initial rate period, and the second figure denoting the adjustment interval after the initial rate period ends. A loan on which all adjustments are at 5 year intervals would be designated a 5Y/5Y. There are a lot more 5Y/1Ys than 5Y/5Ys in the marketplace, because investors prefer the first and lenders have found that borrowers don't much care. This may be because borrowers don't look much beyond 5 years, or they don't fully comprehend the difference, or both. The rule for subsequent rate adjustments is exactly the same as the rule for the first rate adjustment except that the rate adjustment cap applies to the change from the preceding rate rather than from the initial rate. Also, the rate adjustment cap on 5/1, 7/1 and 10/1 ARMs is usually larger on the first rate adjustment than on subsequent adjustments. The Rate Adjustment Process Under Stable Market Rates In comparing one ARM with another or with an FRM, it is best to proceed in 2 stages. In stage one, you examine what will happen to the ARM if the value of the rate index does not change from its initial level. Since all the various indexes to which ARMs are tied tend to move with the general market, we call this a "no-change interest rate scenario". If the initial rate on the ARM is below the fully indexed rate at that time, which is usually the case, then the rate on the ARM will rise on a no-change scenario. In some cases the rate increase on a no-change scenario can extend over many adjustments. For example, the rate on a 1Y/1Y with an initial rate of 3%, a fully indexed rate of 8%, and a rate increase adjustment cap of 1%, will increase by 1% for 5 consecutive years before leveling off at 8%. A borrower who can qualify with either an FRM or an ARM might find an ARM advantageous if there is an interest cost saving on a no-change scenario over the period the borrower expects to be in the house. For example, the rate on a 30-year FRM is 7.25% and on a 7Y/1Y ARM it is 7% for 7 years, going to 8.25% in year 8. If the borrower is confident about being out of the house within 7 years, the ARM would save the borrower money regardless of what happens to rates within the 7 year period. If the borrower guesses wrong about being out of the house within 7 years, however, and especially if rates have risen in the meantime, the borrower may do worse than if she had originally selected the FRM. Borrowers need to compare the near-term benefit of the ARM with the risk down the road. The Rate Adjustment Process if Interest Rates Go Through the Roof A good way to determine whether the cost savings realized on an ARM in a stable interest rate environment are worth the risk is to assess what would happen to the rate on the ARM if the index value jumped to 100% immediately after the loan closed. This is a "worst case scenario." There is comfort in knowing that you can deal with the very worst that can happen, especially since the likelihood of it actually occurring is very low. In comparing different types of ARMs, a comparison of worst cases is a revealing indicator of their relative risk. If one ARM has a small advantage over another on a no-change scenario but a large disadvantage on a worst-case scenario, you could well decide that the benefit associated with the first is not worth the risk. The rule for determining future rates on a worst case scenario is that at each rate adjustment the new rate is the lower of a) the previous rate plus the rate increase adjustment cap, and b) the maximum allowable rate. The following are some examples: A 1Y/1Y ARM has an initial rate of 6%, an adjustment cap of 1% and a maximum rate of 11%. The rate on a worst case scenario would be 6% in year 1, 7% in year 2, 8% in year 3, 9% in year 4, 10% in year 5, and 11% in years 6 and thereafter. A 5Y/5Y ARM has an initial rate of 7%, no adjustment cap, and a maximum rate of 12%. The rate on a worst case scenario would be 7% for the first 5 years and 12% thereafter. A 7Y/1Y ARM has an initial rate of 7%, an adjustment cap of 2%, and no ceiling. The rate on a worst case scenario would be 7% for the first 7 years, 9% in year 8, 11% in year 9, 13% in year 10, etc., the 2% annual increases continuing for the remaining life of the mortgage. The calculator Mortgage Payments on Adjustable-Rate Mortgages allows you to determine how the interest rate and monthly payments will change on an adjustable rate mortgage under no-change, worst case, and a variety of other interest rate scenarios.  This calculator applies only to ARMs that do not permit negative amortization. Negative Amortization on ARMs On most ARMs, whenever the interest rate is changed the mortgage payment is also changed by the amount needed to pay off the loan fully at term. The new payment is said to be "fully amortizing." There are some ARM contracts, however, in which it is possible for the payment to be less than fully amortizing, and even to fall short of covering the interest. When the payment is less than the interest, the difference is added to the loan balance and is referred to as "negative amortization". Negative amortization can arise on ARMs with any of the following features: Low Initial Payments: Some ARMs set the initial payment below the interest payment, which generates negative amortization. More Frequent Rate Adjustments Than Payment Adjustments: If the rate adjusts every year but the payment adjusts every 5 years, large rate increases will lead to negative amortization. Payment Adjustment Caps in Lieu of Rate Adjustment Caps: Payment adjustment caps limit the size of the change in payment, regardless of the size of the change in rate. Hence, a large rate increase will result in negative amortization. In the market today, the most important ARM with the potential for negative amortization is the monthly adjustable. The interest rate is adjusted every month, there are no rate adjustment caps but there is a rate maximum, and the payment adjusts once a year subject to a payment adjustment cap of 7.5%. For example, I looked at a monthly adjustable with an initial interest rate of 7.75% and a maximum rate of 12%. If markets rates exploded the month after this loan was closed, the rate would rise to 12% immediately, but the payment would not change for another 11 months, and then only by 7.5%. The payment would fail to cover the interest for 6 years, with the loan balance rising to 109% of its original value before it started to come down. All other things equal, caps on interest rate adjustments are much better for the borrower than caps on payment adjustments that can result in negative amortization. The problem is that other things are seldom equal. The monthly adjustable described above had a smaller margin, and was tied to an interest rate index that had a lower value than the index used by ARMs with rate adjustment caps. The upshot was that the monthly adjustable would perform better in a stable or declining rate environment, but worse in a rising rate environment, than other ARMs that have rate adjustment caps. Copyright Jack Guttentag 2002

Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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