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22 March 2004
"Could you give me the
pros and cons of COFI loans?"
"My broker said I need a Libor ARM. What is that?"
"The loan officer said an MTA loan was the best. Is that true?"
These 3 questions illustrate a common but
confusing practice in the way adjustable rate mortgages (ARMs) are marketed.
Loan officers often identify different types of ARMs by the interest rate index
they use. COFI, Libor and MTA are all rate indexes. The sales pitch is based on
one feature, often the index itself.
This is misleading because ARMs have multiple
features, some more important to the borrower than the one being pitched. Here
is the list of major features for ARMs that do not permit negative amortization.
1. Index
2. Initial rate period and subsequent
adjustment period. In the trade, these two numbers are usually used to
classify ARMs. For example, an ARM on which the initial rate holds for 3 years
and is then adjusted every year is a "3/1".
3. Most recent index value and margin.
The sum is called the "fully indexed rate", or FIR. For example, if
the current value of the index is 2% and the margin is 2.5%, the FIR is 4.5%. If
the index does not change over the initial rate period, the new rate will be the
FIR, subject to the first adjustment cap.
4. Rate Adjustment Caps: These
limit the size of any change in rate. Caps on the first rate adjustment can
range from 1%, which would be common on an ARM that adjusts after 6 months, to
5% on an ARM that doesn't adjust for 10 years. Caps on subsequent adjustments
are usually 1% or 2%. As an illustration, a 7/1 ARM might have a cap of 5% on
the first adjustment and 2% on all subsequent adjustments.
5. Maximum Interest Rate:
This is the highest interest rate allowed on the ARM over its life. It is often
defined as a spread above the initial rate.
Because these features can vary widely among
ARMs that use the same rate index, the notion of "pros and cons" for
ARMs that use a particular index doesn�t make any sense. For example, one
lender I know offers 9 ARMs that use Libor. Here are two that illustrate my
point most dramatically:
6 mos/6 mos:
The initial rate of 2.125% holds for 6 months and is adjusted every 6 months
thereafter to equal Libor plus a margin of 2.25%. All rate changes are capped at
1.5% with a maximum rate of 15.125%.
10/1:
The initial rate of 5.625% holds for 10 years and is adjusted every year
thereafter to equal Libor plus a margin of 2.75%. The first rate change is
capped at 5%, subsequent changes at 2%, with a maximum rate of 10.625%.
It is easy to understand why loan officers
avoid these details if possible. They take time to explain. Getting involved in
details violates Salesmanship 101.
Borrowers should demand the information shown
above for any ARM being offered them, but they should not depend on loan
officers to assess it. They can do that better themselves. Here is how:
The bottom line is how the ARM rate and
payment may change in the future, relative to other ARMs or to fixed-rate
mortgages (FRMs). You can determine this from calculators available on-line,
including my calculator 7a which was designed for just this purpose.
You have to feed the calculator the
information it needs to do its job. Part of this is the data on features
described above which you get from the loan officer. The second part is your
assumptions about how the index will change in the future. You should use
multiple assumptions that bracket the relevant possibilities. These are the 5
that I often use:
1. No Change: the index stays where it is
now.
2. Small rate increase: after 2 years, the
index increases by .5 % /year for 3 years.
3. Moderate rate increase: after 1 year,
the rate index increases by .75%/year for 4 years.
4. Larger rate increase: starting
immediately, the index increases by 1%/year for 5 years.
5. Worst case: the ARM rate immediately
goes to the maximum allowed by the note.
My calculator 7a will allow you to use any or
all of these scenarios, or any others including rate declines.
The calculator results won�t tell you which
ARM is the best, but it will allow you to make an intelligent selection � and
avoid the unpleasant surprises that sometimes await those who passively accept
the ARM recommended to them.
Copyright Jack Guttentag 2004
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