Adjustable Rate Mortgage

As a borrower prepares to buy a home, he/she needs to decide what type of mortgage is appropriate. Usually, that means choosing between a fixed-rate mortgage and an adjustable-rate mortgage.

The adjustable-rate mortgage may be right if:

• The borrower wants to qualify for a higher mortgage amount, at a lower rate, than would be available with a fixed-rate mortgage
• The borrower is thinking of staying in the home for a relatively short period of time (for example, seven years or less)
• The borrower wants a lower initial monthly payment than is available would get with a fixed-rate mortgage
• Having a monthly payment that stays the same over the life of the loan is not a priority

The following article discusses what the ARM is, how it works, and its pros and cons.

As the illustration tables in this article show, the ARM is considerably more complex than is the fixed-rate mortgage. ARMs are comprised of five components that a borrower should understand:

• The initial period
• The adjustment frequency
• The index
• The margin
• The cap

Understanding how these five components work together in an ARM can help a prospective borrower decide whether the ARM suits their financial needs and goals.

As a prospective homeowner prepares to buy a home, they need to decide what type of mortgage is appropriate for their needs. For most people, the first step in choosing financing is to decide whether to borrow money using a fixed-rate mortgage (FRM) or an adjustable-rate mortgage (ARM).

Fixed-rate mortgages, as their name implies, have interest rates and monthly payments that do not change over the life of the loan.

ARMs, on the other hand, have variable interest rates, and the monthly payment may go up or down accordingly.

Whether a borrower chooses a fixed-rate mortgage or an adjustable-rate mortgage will largely depend on individual circumstances, needs, and goals. For example, a fixed-rate mortgage may be the right choice if a borrower:

• Is thinking of staying in the home for at least five to ten years, or more
• Wants payments that remain constant over the life of the loan

On the other hand, an ARM may be the right choice if the borrower:

• Plan to stay in the home for a relatively short period of time (e.g., seven years or less)
• Want lower initial monthly payments, and can handle potential future payment increases
• Want to qualify for a higher mortgage amount, and expect income to increase over time

This article focuses on the ARM, and helps a prospective homeowner decide if an ARM meets their financial needs and goals, by answering the following questions:

• What is an adjustable-rate mortgage?
• How does it work?
• What are the pros and cons?

What is It?

At its most basic, an ARM is a mortgage whose interest rate varies, or adjusts, over time.

For generations, when most people thought of a mortgage, they did not think of ARMs. Instead, they thought of fixed-rate loans, in general, and the 30-year fixed product, in particular. However, in recent years that thinking is changing. Today, although fixed-rate mortgages remain the industry standard, more buyers are choosing ARMs than in the past.

ARMs have increased in popularity because these days, borrowers often won't remain in a home for long periods of time. Unlike our parents or grandparents, who remained in their homes for at least 30 years, today we are much more likely to remain in a home for seven years or less. Therefore ARMs, with their lower initial interest rates, have become more attractive.

When we say that the initial interest rate on an ARM is "lower," we mean that it is lower than the market rate on a comparable fixed loan. Then, the ARM rate changes up or down as time goes on, and usually, it rises eventually. Prevailing wisdom is that if a borrower holds an ARM long enough, the interest rate will eventually surpass the going rate for a fixed-rate mortgage. For this reason, ARMs tend to be better suited for borrowers who do not plan to remain in their homes for long periods.

How does an Adjustable-Rate Mortgage work?

ARMs are comprised of 5 key components:

• The initial interest rate period
• The adjustment frequency
• The index
• The margin
• The caps

We will examine each component in turn.

The initial interest rate period

The initial interest rate is fixed for a set period of time. The most common initial ARM periods are 1, 3, 5, 7 or even as long as 10 years. Generally, the shorter the initial period, the lower the initial rate.

This lower initial rate can be advantageous because it allows a prospective homeowner to:

• Qualify for the mortgage at a lower rate than they would need to for a fixed-rate loan
• Qualify for a higher mortgage amount than they would for a fixed-rate loan

Once the initial period ends, the ARM rate will adjust either up or down depending on current prevailing interest rates. How often that happens is known as the "adjustment frequency," to which we turn next.

The adjustment frequency

The adjustment frequency is the amount of time between interest rate changes. With many ARM products, adjustments occur once a year.

One can tell what the initial periods and adjustment frequencies are by looking at an ARM product's name.

For example, a prospective homeowner may see ARM products called 1-1, 3-1, or 5-1 ARMs. The first number is the initial period of the loan, during which the interest rate will remain fixed, and the second number shows how often the rate will adjust after that. If the second number is a 1, then the rate will adjust once a year.

With ARMs, it is important to note that the rate is comprised of 2 parts - the index and the margin. The index, which we will examine next, is the part of the ARM rate that changes, while the margin stays the same.

The index

Most lenders tie ARM interest rate changes to changes in an "index rate." Indexes move up or down with the general movement of interest rates.

Common indexes to which ARMs are tied include:

• Constant Maturity Treasury (CMT)
• Treasury Bills (T-Bills)
• 11th District Cost of Funds Index (COFI)
• Cost of Savings Index (COSI)
• Certificate of Deposit Index (CODI)
• 12-Month Treasury Average (MTA)
• London Interbank Overnight Rate (LIBOR)

Each ARM is linked to a particular index. The most frequently used indexes today are the CMT, COFI and LIBOR - approximately 80% of today's ARMs are tied to one of these.

If a buyer is in the market for an ARM, they should be sure to ask the lender how often their loan indexes change, and how the indexes have behaved historically. For example, the COFI is known as a "lagging" index - it increases at a much slower rate than do many of the other indexes, making it particularly attractive in times of rising interest rates.

As noted above, the index is the part of the ARM interest rate that changes. The margin, which we will look at next, does not change.

The margin

Put simply, the margin is the "mark-up" that the borrower's lender adds to the index to come up with the total ARM rate. Unlike the index, which changes, the margin stays the same over the life of the loan. The margin is the profit that the lender is making from the loan.

If a prospective homebuyer is shopping for an ARM loan, they should be sure to look at both the index and the margin. Different lenders may charge lower or higher margins, and that affects the monthly payment even if the lenders use the same index. The following example illustrates this.

As the above table shows, Lender 1 and Lender 2 have the same first-year index (3.5%). However, Lender 2's higher margin means that the initial ARM rate is 6% instead of 5%, and that would cost the borrower an extra $125.46 per month.

To reiterate, the margin does not change over the life of the loan, but is added to the index, which does change.

In order to protect borrowers from large payment spikes that could occur because of changing indexes, most ARMs come with "caps" or ceilings.

The caps

To protect borrowers from extreme increases in monthly payments, most ARMs have caps. These caps fall into two categories: interest-rate caps and payment caps.

Interest rate caps come in 2 varieties: periodic caps and overall caps.

Periodic caps limit the amount the overall interest rate can increase from one adjustment period to the next. Not all ARMs have these.

The following table illustrates how a periodic cap can affect the monthly ARM payment from year one to year two.

Bob is looking to borrowing money to purchase his first house. Let us say Bob has a $200,000 ARM loan with an initial rate of 5% and periodic interest rate cap of 2%. At the first adjustment, the index rate goes up 3%. Here is how Bob's monthly payment is affected:

As this example shows, the periodic cap would keep Bob's year-two interest-rate from rising to 8%. Instead, his year-two interest-rate would be 7%, which would save him $136.93 in monthly payments.

Overall caps limit how much the interest rate can increase over the life of the loan. Since 1987, overall caps have been required by law.

Let us look at an example of how an overall rate cap of 5% would affect a loan using Bob as an example, once again. On a $200,000 ARM with an initial rate of 5% and an index that increases 1% in each of the first 10 years, here is what the monthly payment would be by year ten, with and without the cap.

Without the cap, Bob is paying substantially more by year ten than he would with the cap. The 5% overall cap on this loan means that Bob's interest ratOFLe would never go above 10%, and his monthly principal and interest payment would never exceed $1,755.14.

Payment caps are different from interest-rate caps. A payment cap limits how much the monthly payment can increase at each adjustment, usually to a percentage of the previous payment. Usually, ARMs with payment caps do not have periodic rate caps.

The following example shows how much the monthly payment can increase from years one through five on an ARM loan with a 7.5% payment cap. In other words, each year the monthly payment can only increase to 7.5% of the previous year's payment.

Borrowers who favor ARMs with payment caps say that the caps help make their increase in monthly payments predictable. They further say that they are reaping the benefits of lower initial ARM rates, while knowing in advance how much their monthly payments can increase each year.

However, one of the potential risks involved with ARMs that have payment caps is that there is the potential for "negative amortization."

Amortization means that payments are large enough to pay for the interest due plus a portion of the principal.

"Negative amortization" occurs when payments do not cover the cost of the interest. Instead, the unpaid interest is then added back to the loan amount, where it generates even more interest debt. If this continues, the borrower could make many payments but end up owing more than he owes or she owes at the beginning of the loan.

Recently, to mitigate the risk of negative amortization, lenders who offer ARMs with payment caps have begun to offer borrowers a "four-payment" option on their monthly bill. The options work as follows:

• Option 1: Minimum payment - may or may not be enough to cover the cost of interest as rates adjust; negative amortization could result from consistently choosing this option
• Option 2: Interest-only - will cover the cost of interest and help prevent negative amortization
• Option 3: 30-year amortization - will cover the cost of interest plus principal based on a 30-year amortization schedule
• Option 4: 15-year amortization - will cover the cost of interest plus principal based on a 15-year amortization schedule

A key benefit of the "four-payment" option is that a borrower can choose how much they wish to pay each month on the mortgage. The borrower only has to pay the minimum amount, but can also pay more when they have the resources/desire to do so. Borrowers who favor this feature say that the "four-payment" option is beneficial because they, not the bank, are controlling the monthly cash flow.

What are the pros and cons?

As we have seen, an ARM is an appropriate choice if low payments in the near term are the primary concern, and/or the borrower does not plan to live in the property long enough for the rates to rise.

Whether a borrower chooses the ARM depends on their plans for the home, and on the overall financial picture.