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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