Adjustable Rate Mortgages (ARMs)
Adjustable Rate Mortgages are called ARM loans. The have many different features and terms, but all of them adjust at some period of time during the mortgage term. FHA, VA, Fannie Mae, Freddie Mac, Niche Products, Sub-Prime, Alt-A, and Jumbo loans all have ARM loans that can be obtained with their product. There are several important features and terms you must understand before getting an ARM loan, or before you can adequately evaluate, if an ARM loan is right for you. Here are the terms and what you need to know.
- Index - The index is the published interest rate standard, which your rate will be based once the loan interest rate adjusts. Let me give you an example. Many ARM’s use the one year treasury note to adjust. This is the index which your loan will adjust with when the rate changes. In addition to this index, you will be charged the Margin (you are not as good a credit risk as the US Government is why). Here are the most common indexes and to get the current index rate you may click the link.
- One Year Treasury (CMT) - This is also noted Constant Maturity Treasury Rate or CMT. http://www.moneycafe.com/library/cmt.htm.
- 12 Month Treasury Average (MTA) - This is the 12 month of the monthly average of the US Treasury notes adjusted to a constant maturity of one year. The rate history can be found at http://www.moneycafe.com/library/mta.htm.
- 6 month London Inter-Bank Offering Rate (LIBOR) - This is the 6 month term LIBOR rate. http://www.moneycafe.com/library/6mlibor.htm.
- 11th District Cost of Funds Index (COFI) - This is the weighted average cost of bank borrowings for the San Francisco Federal Home Loan Bank. This rate can be found at http://www.moneycafe.com/library/cofi.htm.
- Cost of Savings Index (COSI) - This is the Cost of Savings Index of Wachovia Bank. The rate is http://www.moneycafe.com/library/cosi.htm.
- Certificates of Deposit Index (CODI) - This is calculated by averaging the previous 12 month rates for the 3 month Certificates of Deposit. This rate can be found at http://www.moneycafe.com/library/codi.htm.
These are the major Indexes used by banks. The COSI is only available at Wachovia Bank or a broker who sales to Wachovia Bank. It is not important that you know their name, but (1) what there current rate is and (2) what has been there trend over the past several years. By clicking on the links above you can compare these Indexes to one another to understand your potential risk. Just because a history of an Index has been stable note that is no guarantee that it will continue to be so.
- Margin - The Margin is the interest rate spread above the Index that you will have to pay once your ARM loan adjusts. For instance a typical Margin for a Fannie Mae or Freddie Mac loan is 2.75%, so if you Treasury index is 2.5% and the margin is 2.75% then when your loan adjust it will be these two items added together or 5.25%. This rate is subject to the interest rate caps and floors.
- Caps - A Cap or interest rate Cap is the maximum interest rate your loan can rise during interest rate adjustment period. In other words, if the like the scenario above your current interest rate is 4.0% and your periodic Cap rate is 2% then the maximum rate adjustment can be no more than 6% or 4% + 2%. There are generally two or three different Caps on ARM loans. I will try and explain each.
- Initial Rate Cap - This the maximum rate your loan can adjust on the very first interest rate change. Generally only Sub-Prime and Alt-A use this cap separate from the periodic cap (listed below). It will show up like this 6/2/6 (the highlighted and underlined number is the initial rate cap). What this means is the your interest rate can go up as much as 6% above your initial interest rate you paid, so if your loan started at 4% the Margin went up significantly, then your interest rate could go up to as much as 10% (initial interest rate 4% + initial rate cap of 6% = 10%. The margin plus the index must be equal to or greater than 10% for this to happen, but it can happen). The initial rate cap and the periodic rate Cap can be the same. This is the case for all FHA, VA, Fannie Mae and Freddie Mac and most Jumbo loans.
- Periodic Rate Cap - This is the maximum rate your loan can move for each adjustment period on a ARM loan. This number can be the same as the initial rate cap if two numbers are used. It will be reflected by 2/6 caps (the highlighted and underlined number is the periodic cap). If there is a different initial rate cap, the periodic rate cap will be designated as 6/2/6 (The highlighted and underlined number is the periodic cap).
- Loan Rate Cap - This is the interest rate cap for the life of the loan. In other words, your interest rate cap can not exceed the initial rate plus this figure. It will be denoted by the final number 2/6 or 6/2/6. If your initial interest rate is 4% the maximum interest rate on your loan can never exceed 10% if 6% is the loan cap.
- Floor - This is the lowest and interest rate can go. Many loans have that the initial interest rate is the loans floor, so get an attorney to read the documents. Obviously, the floor can never go lower than your margin (remember Margin + Index = new rate), and that assumes the Index goes to zero percent (which will never happen).
With this knowledge you are now ready to tackle the complex world of ARM loans. See the chart below to look at a good sampling of the ARM loans available:
|
Loan Name |
Loan Type |
Fixed Term |
Adjustable Term |
Index |
Margin |
Caps |
|
FHA ARM |
FHA |
1 year |
Every year thereafter |
CMT |
1.75% -2.25% |
1/5 |
|
VA 3/1 ARM |
VA |
3 years |
Every year thereafter |
CMT |
2.00% - 2.25% |
1/5 |
|
VA 5/1 ARM |
VA |
5 years |
Every year thereafter |
CMT |
2.00% - 2.25% |
1/5 |
|
One Year ARM |
Conventional Jumbo |
1 year |
Every year thereafter |
CMT, MTA, COFI, COSI, CODI & LIBOR |
2.25% - 3.25% |
2/6 |
|
2/28 ARM |
Sub-Prime Alt-A, & some Jumbo |
2 years |
Every 6 months thereafter |
LIBOR |
3.25% - 6.75% |
6/2/6 or max rate 14%+ |
|
3/27 ARM |
Sub-Prime Alt-A, & some Jumbo |
3 years |
Every 6 months thereafter |
LIBOR |
3.25% - 6.75% |
6/2/6 or max rate 14%+ |
|
3/1 |
Conventional & Jumbo |
3 years |
Every year thereafter |
CMT, MTA & LIBOR |
2.75% - 3.25% |
2/6 |
|
5/1 |
Conventional & Jumbo |
5 years |
Every year thereafter |
CMT, MTA & LIBOR |
2.75% - 3.25% |
2/6 |
|
7/1 |
Conventional & Jumbo |
7 years |
Every year thereafter |
CMT, MTA & LIBOR |
2.75% - 3.25% |
2/6 |
|
10/1 |
Conventional & Jumbo |
10 years |
Every year thereafter |
CMT, MTA & LIBOR |
2.75% - 3.25% |
2/6 |
|
5/25 |
Freddie Mac |
5 years |
One change at year 5 and then fixed for 25 years |
CMT, MTA & LIBOR |
2.75% - 3.25% |
N/A |
|
7/23 |
Fannie Mae |
7 years |
One change at year 7 and then fixed for 23 years |
CMT, MTA & LIBOR |
2.75% - 3.25% |
N/A |
|
Balloon loan |
Banks, Conventional |
5-7 years |
Balance due at Balloon period |
Fixed for 5 or 7 years |
N/A |
N/A |
There are hundreds of variations on these loans including payment and term options. I will try and spell them out simply.
- Term Options on these loans can include payment terms of 10, 15, 20, 30, and even 40 year pay options on some of these loans.
- Payment options can include paying the interest only for the first 5, 7, 10 or even 15 years before the loan starts paying off the principal that will be amortized for the remainder of the term.
- There is even a Pay option ARM product (we will talk about it in the Niche loan section) that allows you four payment options each month including: low interest rate1% -3.99% (this has negative amortization, which means your loan balance will increase; interest only, 15 year amortization, and a 30 year amortization. You get to choose which payment you want for each month. This product has high risk, so thoroughly read the Pay Option ARM section.
Why choose and ARM loan and when should you consider one. To do so all of the following must be considered positive:
- You should have a comfort level with the additional risk you will assume.
- You can comfortably make the fully indexed payment. This means that if your interest rate adjusted today, could you make that payment.
(Remember: New rate = Margin + Index).
- Is the fully indexed rate at least 2% below the below the same products fixed rate term you could have received. Many times the fully indexed rate is actually higher than the fixed rate, so why bother taking on this added risk.
Advantages:
- May have a lower interest rate especially at the beginning of the loan term.
- Good for people who only desire a loan for a period of short duration (i.e. 3-7 years).
- Over historical periods ARMS have stayed lower than fixed rate loans.
- Because of the lower rate, your might can qualify for an ARM where you may not have been able to qualify for a fixed rate loan (but not all the time).
Disadvantages:
- Many have a higher down payment requirement than their comparable fixed rate counterpart.
- You will have interest rate risk you will assume.
- This loan is not generally assumable.
- Rates, especially on Sub-prime loans can change much higher after their initial fixed period.
When you should consider an ARM loan:
- If you are planning to live in the house for a relatively short period of time 9i.e.3-7 years, and the corresponding ARM rate is less than a fixed rate loan.
- If the rate on a fixed rate loan is at least 2% greater than the ARM you are seeking.
Another factor to consider for those looking at an ARM is the amount of time you plan to spend in your residence. If you are only going to be there for 3 years, a 3/1 or a 5/1 ARM might be the right loan for you. That is why there are different fixed rate periods on ARM loans to match the term with the length of period on the house. Be careful, many ARM loans have a higher start rate than a fixed rate loan, so ask questions of your mortgage banker or broker.
MCA offers a product to protect you against potential mortgage fraud and over-charging. It is called the Consumer Protection Plan. A Mortgage Professional will review your initial mortgage disclosure documentation and when the loan is ready to close the MCA professional will also review your closing settlement documents to make sure you received the correct program, rate and fees as initially disclosed.
