[Intro]
The Adjustable Rate Mortgage (ARM) is a flexible loan instrument. An Adjustable Rate Mortgage is one in which the interest rate and the monthly payments may be adjusted periodically to correspond with changes in a selected index. Although the terms of any one loan may vary considerably from another, there are several common characteristics of practically any adjustable rate financing. The following is an attempt to help you understand the “language of ARM’s”.
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INTEREST RATE ADJUSTMENTS: Adjustments to the interest rate must reflect the movement of a single, specific index, subject to any rate adjustment limitations contained in the loan contract.
INDEX: Most common index today is the LIBOR (London Inter Bank Offered Rate) but past indexes included Treasury Bills, Treasury Securities and the 11th District Cost of Funds. Each index is any indicator of current economic conditions that guides lenders in their interest rate adjustments. While claims are made as to which index is the most stable under certain conditions, you can satisfy yourself by examining the recent history of each index over the past three years or so.
MARGIN: The margin is the percentage amount added to the index at each adjustment period to determine the new interest rate to be paid by the borrower. Sometimes known as the “differential” or “spread”, the margin is established by each individual lender based on their estimated expenses and profit goals. While the margin in any given loan remains constant, in relation to the index, for the life of the loan, margins between loans can and do vary.
MONTHLY PAYMENT ADJUSTMENTS: Another flexible feature of an ARM is that the monthly payment amount may be increased or decreased by the lender to reflect changes in the interest rate. The frequency with which such adjustments can occur is determined by the specific terms of the ARM loan acquired by the borrower.
THE CAP: Most loans have a limitation on the amount by which the payment and/or the interest rate can change at any single adjustment. The most frequently used “cap rates” are:
a.) 1% every six months or 2% per year maximum adjustment on interest rate at any one adjustment period; or
b.) 7.5% adjustment on the payment rate at any one adjustment period.
Additionally, there is a maximum rate change that may occur over the full life of the loan, currently between 4 and 6 percent, depending upon the initial start rate. Borrowers are cautioned against over emphasis on this maximum interest rate figure since, in most instances, depending upon the stability of the index and market adjustments, the maximum rate is unlikely to occur.
In those cases where a borrower accepts a payment cap, there can be a difference between the amount due and the amount actually paid. This difference is known as “deferred interest” or “negative amortization” and is added to the balance of the loan. A good understanding of all the loan characteristics is necessary prior to a final judgment of any deferred interest situation.
NOTICE OF PAYMENT ADJUSTMENTS: The lender will send you a notice of an adjustment to the payment amount usually 30 but not more than 45 days before it becomes effective. This notice will contain the date and amount of payment adjustment, loan balance, change in index and interest rate, change in principal loan balance and other related information such as who you could contact for further information and clarification. It is a good idea to retain these notices.
PREPAYMENT PENALTY: Most ARMS may be prepaid in whole or in part without penalty at any time during the term of the loan.
ASSUMABILITY: Many ARM loans may be assumed without change in the loan terms by a “qualified” borrower acceptable to the lender. There is usually an assumption fee of approximately 1% based on the then remaining unpaid principal balance.
The array of Adjustable Rate Mortgages available in today’s mortgage market place has diminished from their hey-day during the sub-prime craze. Should one opt for an adjustable rate mortgage, be certain the lender explains fully and in detail the loan characteristics of your selected loan. You do not want any surprises after the loan process has been completed . . . it is then too late to make adjustments to the terms.
Why Select an Adjustable Mortgage Loan
During the past several years, fixed rate financing has been the most often selected form of home financing for most borrowers. With fixed rates continuing to hover just above 4%, they remain the popular financing choice. As the rate of property appreciation has moderated, homebuyers anticipate that they will likely remain in any newly purchased home rather than “move up” anytime soon. This may suggest that homeowners may stay in their homes for a longer period of time . . . perhaps eight or more years. Regardless of the “holding time”, many homebuyers still prefer the comfort of knowing what their payment is going to be each and every month as is the case with fixed rate financing. On the other hand, when fixed interest rates increase, Adjustable Rate Mortgages (ARM’s) often become a bit more popular. There are a few additional times when an ARM loan might make sense.
IF THE BORROWER CAN QUALIFY FOR A LARGER LOAN AMOUNT: While this may have been true several years ago, this may be more of a myth than reality in today’s ARM market. In the past, a borrower actually “qualified” at the low ARM start rate which resulted in their being able to borrow more money and purchase a more expensive home. Most ARM products today, however, require a borrower to qualify at the “start rate plus 2%” or at the “fully indexed rate”. The latter is the “index” plus the margin. (i.e.; we add the margin of 2.25% to an estimated LIBOR Index of 2.70% and the fully indexed/qualifying rate would be 4.95%). This “fully indexed rate” is at best usually only approximately .75% less than a comparable fixed rate and will hardly allow a borrower to qualify for much additional loan amount.
WHEN A BORROWER WANTS LOWER INITIAL PAYMENTS: An ARM with a very low start rate (i.e.; 1.75% to 2.5%) is more likely to have negative amortization than a higher start rate loan. These “Neg Am” loans can result in an erosion of one’s equity. Typically, the borrower is provided the option each month to pay (1) either the minimum payment , (2) a higher payment that will, at least, pay all the interest, or (3) a payment amount that will fully amortize the loan. While the initial payment amount may be predicated on the initial low interest rate, the loan accrues interest at the fully indexed rate (described above), resulting in unpaid interest having to be added to the loan balance . . . this is the “negative amortization” or “deferred interest”. As home appreciation rates remains minimal lenders are more reluctant to make this kind of loan where equity is eroded.
While these loans may be less popular than a few years ago when double digit appreciation more than equaled any negative amortization, this type of ARM “controls the loan’s payments” as they increase a maximum of only 7.5% each year. Thus, for those who need to have a low monthly payment and need to know exactly the amount of each year’s increase, these loans may be one answer. These loans are more likely to have pre-payment penalties assessed during the first three years of the loan. Depending upon the borrower’s specific need for lower initial payments, the 30 due in 3, 5 or 7 year fixed rate might be an alternative to the ARM loan.
The negatively amortized loan is not readily found at present. But, there are efforts to re-introduce more flexible loan instruments and history does have way of repeating itself.
Be cautious of such financing.
WHEN THE BORROWER WANTS TO MAKE PRINCIPAL REDUCTION PAYMENTS: In those situations when a borrower desires to make significant principal reduction payments, the “no-neg” ARM loan (without a pre-payment penalty) may be appropriate as the payment will reduce according to the amount of the principal reduction at the loan’s next adjustment date. This occurs most frequently when a buyer purchases prior to selling a current residence. The intent is to extract their equity upon the future sale of their residence and make a significant “principal pay down” payment on the new loan.
Adjustable Rate Mortgages remain available in today’s mortgage market place albeit with lesser choices than in past years. There are times when an ARM makes perfect sense. When acquiring such financing, a borrower must be certain to understand all of the characteristics of the selected loan. It is important to avoid surprises after the loan process has been completed and it is too late to make adjustments to the loan terms.
New loan options are being advertised as non-QM loans, meaning they are not subject to the oversight of the Fannie Mae and Freddie Mac loans. These loans are more likely to offer adjustable rates (along with higher fixed rates) for those borrowers who have blemished credit or are, for other reasons, unable to qualify for more conventional or government loan options.
NOTE: The “Option Arm” Loan program that was so popular during the sub-prime boom, has all but disappeared. While it provided three payment options to the borrower, the lowest payment option was the one most often selected. This was a Negatively Amortized payment plan that resulted in sizeable deferred interest being added to the loan balance each month. Borrowers often acquired 100% financing with this loan and worse still, qualified at the lowest payment amount. When real estate values adjusted downward, there was little if any equity contained in the property with which to allow refinancing. Coupled with the pending adjustment of the ARM portion of the loan to a much higher rate and accompanying payment, borrowers were squeezed and unable to either make the higher payments or sell their homes. The result was a sizeable increase in foreclosures. Many borrowers discovered that they had merely rented their homes for a few years before having to abandon them to the lending institutions via foreclosure. No wonder, this financing option has virtually disappeared!