An ARM, short for "adjustable rate mortgage",
is a mortgage on which the interest rate is not fixed for the entire
life of the loan. The rate is fixed for a period at the beginning,
called the "initial rate period", but after that it may change based on
movements in an interest rate index.
The ARM rate quoted by a lender or broker
is the initial rate. It holds until the end of the fixed-rate period,
which can last from a month to 10 years. This rate is critically
important if the initial rate period lasts for 10 years, but it is very
unimportant if the period is only one month.
On the most popular ARM program, the initial rate period is 12 months, and on more than half the
period is 36 months or less. While you can always opt for an ARM with a
longer initial rate period, the rate goes up as the period lengthens. If
you need the rate on a one-year ARM to qualify, you must consider very
carefully what happens after the fixed-rate period ends.
You should answer this
question in two stages. In stage one, you make the assumption that
market interest rates don't change from the time you take out the loan.
This provides an excellent baseline for comparing ARMs. In stage two you
assume that interest rates explode. This provides a measure of the
riskiness of the ARM. Call these "no change" and "worst
case" scenarios.
To perform the analysis,
you need to get 5 pieces of information about the ARM from the loan
officer:
1. The most recent
value of the interest rate index to which the rate on your ARM is
tied.
2. The margin that
is added to the index value to determine the rate.
3. The rate adjustment
period, which is the frequency with which rates are changed after
the initial fixed-rate period is over.
4. The rate
adjustment cap limiting the size of any rate change, if
any. WARNING: ARMS THAT HAVE INITIAL RATE PERIODS OF 5 YEARS OR
MORE AND RATE ADJUSTMENTS ANNUALLY THEREAFTER ARE LIKELY TO HAVE
HIGHER RATE CAPS ON THE FIRST THAN ON SUBSEQUENT RATE ADJUSTMENTS.
5. The maximum rate
over the life of the loan.
On a no-change scenario the
rate on the ARM will move toward the sum of the index value plus the
margin, sometimes called the "fully indexed rate". On a
worst-case scenario, the ARM rate will move toward the maximum rate
allowed by the loan contract. If there are no rate adjustment caps, this
will happen at the end of the fixed-rate period.
For example, assume the
initial rate on a one-year ARM is 5%, the index value is 4.5%, margin is
2.5% and maximum rate is 11%. At the end of the fixed-rate period, the
new rate will be 4.5% plus 2.5% or 7% if the index didn't change, and it
will be 11% if the index jumped by 4% or more. This is shown below.
|
No Rate Adjustment Caps
|
| Months |
No-Change
Scenario |
Worst-Case
Scenario |
| 1-12 |
5% |
5% |
| 13-360 |
7 |
11 |
If there is a rate
adjustment cap, however, the adjustment to these new rates will be
stretched out. For example, if there is an adjustment cap of 1% and the
rate adjustment period is one year, the rate changes will look as
follows:
|
1% Rate Adjustment Caps
|
| Months |
No-Change
Scenario |
Worst-Case
Scenario |
| 1-12 |
5% |
5% |
| 13-24 |
6 |
6 |
| 25-36 |
7 |
7 |
| 37-48 |
7 |
8 |
| 49-60 |
7 |
9 |
| 61-72 |
7 |
10 |
| 73-360 |
7 |
11 |
In short, when comparing
ARMs you will want to consider more than just the initial rate and how
long it lasts, which is as far as many ARM borrowers go. Unless you are
sure you will be out of the house before the fixed-rated period ends,
you also want to consider what will happen to the rate, and when it will
happen, on no-change and worst-case scenarios.
A word of warning. The loan
officer will give you all the information you need for this analysis
with the possible exception of the index value, on which he may profess
ignorance. That's OK. It is probably safer to find this number on your
own but you must get a description of the index that is complete enough
for you to identify it. Don't let him tell you it is the
"Treasury bill" series because there are a number of Treasury bill
series.
You can find the most
commonly used indexes, and web-based sources of information about them,
at Adjustable Rate Mortgage Indexes.
Copyright Jack
Guttentag
2004
