Adjustable Rate Mortgages (ARMs)

Great for short term investments or "flipping". Not a great option if you're looking to stay in your home for many years.

Adjustable Rate Mortgages (ARMs) have regularly adjusted interest rates. These adjustments are based on an index. The index is the cost of borrowing to the creditor.

ARMs are the exact opposite of Fixed Rate Mortgages. With ARMs, the amount you'll pay in interest (and monthly payments) over the life of your mortgage fluctuates.

ARM Basics:

  • Initial Rate - interest rate at the beginning of an ARM
  • Adjustment Period - length of time where initial interest rate will be fixed. At end of this period, the interest rate and monthly loan payment will be recalculated
  • Index Rate - Lender choses index, rate determined by specific index
  • Margin - percentage lenders add to the index rate, determines total interest rate
  • Initial Discount - promotional reduction in interest rate, usually offered for the first year of an ARM
  • Caps - limit placed on how high interest rates or monthly payments can go up at the end of each adjustment period
  • Negative Amortization - occurs when the monthly mortgage payment isn't large enough to cover the interest owed. Leads to an increased mortgage loan and reduced equity over time
  • Conversion - clause that allows borrowers to convert the ARM to a fixed rate mortgage
  • Prepayment - penalty amount if borrower pays off the mortgage early

Interest Rates:

ARM interest rates are fixed for either five or seven years. When this period ends, interest rates adjust up or down.

Who determines adjustments? Interest rates for ARMs are typically modified based on an index. This index tells banks (and mortgage lenders) how much it will cost to borrow money.

Occasionally, the index is spelled out clearly in the text of your loan. The language may be a direct and legally defined link to the index. In cases where no such language exists, it's completely up to the lender.

The most common indices are:

  • 1-year Constant-Maturity Treasury (CMT) securities
  • Cost of Funds Index (COFI)
  • London Interbank Offered Rate (LIBOR)

The Constant Maturity Treasury securities are issued by the Federal Reserve Board. This index is based on the monthly average yield of a range of Treasury securities. Maturity for these securities is set at one year.

Mortgage lenders use this index to adjust interest rates as economic conditions fluctuate. They typically inflate the index by adding percentage points on top of the index rates. Those percentage points are called a margin. The index plus margin equal the total interest rate you'll pay.

Interest rates tied to this index increase or decrease as the index goes up or down. The 1-year CMT securities index is one of the more stable indices. It's considered less volatile than daily interest rate movements. And more volatile than other indexes like the COFI.

The Cost of Funds Index (COFI) is an average of interest expenses incurred by financial organizations. A regional COFI is made up of financial institutions based on their physical location.

A regional COFI is specified in ARM loan documents. The interest expense rate is usually calculated by a self-regulatory agency like Federal Home Loan Banks. A self-regulatory agency is a private group that has the power to create and enforce industry regulations and standards.

ARMs based on COFI are preferred. Interest rates based on COFI loans and mortgages fluctuate less than loans linked to other indexes.

The London Interbank Offered Rate (LIBOR) is an average of interest rates. These interest rates come from leading banks in London. And are an estimation of what banks would be charged if they borrowed money from other banks.

"Thomson Reuters publishes LIBOR rates daily. The LIBOR rates are calculated during 7 different periods, ranging from overnight to one year. And are computed for 5 different currencies.

Over $350 trillion in financial products are linked to the LIBOR. Many banks, credit card companies, mortgage lenders and other financial institutions set their rates relative to it.

In 2013, several sweeping reforms were recommended and applied to the LIBOR. Oversight and regulation of the LIBOR is performed by the British government.

Why should you care about ARMs and the indices they're based on? Interest rates are used to determine the total cost of your mortgage. And are based on these indices. If they go up, your mortgage and monthly payment go up as well.

Caps:

Most ARMs include details regarding caps. These caps help limit the risk of ARMs. And are applied to the following aspects of an ARM:

  • frequency of the interest rate change
    • adjustments made every six months, typically 1% per adjustment, 2% total per year
  • periodic change in interest rate
    • can be broken up, 4% on the initial adjustment and 2% on subsequent adjustments
  • total change in interest rate over the life of the loan (life cap)
    • limited to 6% or 7% for the life of the loan

Sometimes the language for caps will be stated as "initial cap/ following cap/life cap". It may look something like this: 3/3/6.

The initial cap is 3%. Follow up cap is 3%. And the cap on total interest adjustments is 6%.

If only two numbers are provided, this means the initial and follow up caps are the same. Instead of 3/3/6, it would state 3/6.

One thing to keep in mind, if the initial fixed rate period is on the longer side, you risk a larger interest rate adjustment. Banks favor shorter periods. If they must wait too long to adjust your rate, they're going to make you pay for it.

It's rare, however, on occasion lenders will use language in mortgages to limit the monthly payment amount. For example, it may say monthly payment amount not to exceed $1200. It's more of an absolute than relative.

Alternative ARMs:

Cash Flow ARM

  • This type of loan offers a range of monthly payment choices to the borrower
  • Most options include paying at the 30-year level, 15 year level, interest only or minimum payment
  • This last option is usually the lowest amount. And is typically only offered for the first couple of years of the loan
  • Cash Flow ARMs can lead to negative amortization
  • Also known as option ARM or payment option ARM mortgages
  • Can be used for fixed rate loans as well. Same options are available; however, they remain fixed for 30 years.

Hybrid ARM

  • This loan has a combination of fixed and adjustable rate features
  • Described by their initial fixed-rate and adjustable-rate periods
    • Example: you may see a hybrid ARM described as 3/1. This is for an ARM that has a 3-year fixed interest-rate period, followed by 1-year interest-rate adjustment periods
  • Have become increasingly popular over the past several years

Option ARM

  • Like Cash Flow ARM
  • Typically offered for 30 years and has four different payment options:
    • Specified minimum payment
    • Interest only payment
    • 15 year fully amortizing payment
    • 30 year fully amortizing payment
  • Also known as Pick a Payment or Pay Option
  • Usually has a very low interest rate and monthly payment for first year
  • If the economy is good, lenders will allow larger loans due to underwriting mortgages below the fully amortizing payment level
  • Can lead to negative amortization when payment option chosen is less than the accruing interest
    • This means the unpaid portion of the accruing interest is added to the outstanding principal balance each month
    • Example: borrower makes a minimum payment of $1,000. The ARM accrued interest plus payment equals $1,300. This means $300 will be added to the loan's principal amount for that month. And the subsequent month's accrued interest will be calculated on that new principal total
    • Negative amortization reduces the borrower's equity in the property purchased which increases risk in ability to repay the mortgage
  • Risky if long term interest rates go up and/or property purchased doesn't increase in value
  • Can be a good option for borrowers with growing incomes or seasonal income changes
  • Susceptible to "payment shock" if economy goes down the drain
  • Payment shock is when negative amortization and other features of this ARM triggers large payment increases in a short time
  • If the negative amortization on the principal loan amount reaches 110% to 125% of the original loan, then the next monthly minimum payment will be for the fully amortized loan amount.
  • This type of ARM is also available as a hybrid. It typically has a longer fixed rate period. No lower "teaser" rate. And reduces the risk of negative amortization.

Critique:

There were a series of articles and studies done in the 1990's regarding interest rate errors and overcharges by lenders. In 1991 the Government Accountability Office (GAO) published a study of Adjustable Rate Mortgages in the United States.

They found between 20% and 25% of ARM loans contained Interest Rate Errors. At the time, there were over 12 million ARMs in the U.S.

It's estimated these mistakes created at least $10 billion in overcharges to American mortgage holders. Most of these mistakes were the result of using incorrect index dates, incorrect margins, and/or ignoring caps.

Consumer Loan Advocates, a non-profit mortgage auditing firm, revealed in 1994 that as many as 18% of ARMs have errors. The estimated cost in interest overcharges was more than $5,000 per borrower.

In late 1995, regulators from the Federal Savings & Loan Insurance Corporation (FSLIC) issued a report. In this report, they stated 50-60% of all ARMs in the U.S. have errors concerning the variable interest rate charged to borrowers.

Estimates place the overcharged interest totals at more than $8 billion. Major causes of the overcharges were calculation errors, insufficient computer programs, and incorrectly completed loan documents.

A more recent case, from 2010, involved the large mortgage lender Countrywide. The Federal Trade Commission (FTC) levied a fine of $108 million against Countrywide.

The settlement was in response to charges that Countrywide collected excessive fees from borrowers struggling to make mortgage payments. Monies gathered by the FTC were used to reimburse affected mortgage holders.

Why Use an ARM:

With more of the risk being shifted from the mortgage lender to the consumer, why would people use ARMs? Let's review the positive and negative aspects of ARMs.

Pros:

  • Lower initial monthly payment
  • If borrowers are willing to assume the risk associated with interest rate changes, then mortgage lenders are more willing to offer initial lower payments
  • Qualified buyers have access to larger loan amounts
  • Most ARMs have a cap on interest rate adjustments
  • ARM interest rates are usually lower than fixed rate mortgages
  • Great option for those not planning to own the home more than 5 to 7 years

Cons:

  • Fluctuations in interest rate
  • Possibility of large swings in monthly payments
  • No control, at the whim of national and international economies
  • Incomplete, incorrect and/or misleading information provided by lenders

In general, ARMs aren't for the casual mortgage borrower. They can be very complicated and require a certain level of sophistication from those who use them.

If you want to get into a home quickly, have increasing income and don't plan to stay in the home more than five years, then an adjustable rate mortgage could be a great option for you.

Adjustable Rate Mortgage Q & A

Q: Why are so many ARMs based on LIBOR?

A: Banks, mortgage lenders, originators, servicers, Fannie Mae and Freddie Mac all borrow money at a rate tied to LIBOR. So, it makes sense they're willing to lend money at an interest rate also tied to LIBOR.

For example, let's say a large national bank borrows $1 billion at LIBOR plus 50 basis points. The bank decides to offer ARMs with an interest rate of LIBOR plus 100 basis points. This is how they make money from adjustable interest rates.

Q: Are Margins on ARMs negotiable?

A: It depends on who's servicing your loan. If you're going through a lender who's selling a loan onto the Secondary market, then the terms of the mortgage are set. They can't negotiate on margin. The lender can only negotiate on items associated with their compensation, such as points or fees.

If your loan is through a lender who's making the terms and is intending to service the loan, then yes, everything is up for negotiation. These are called "portfolio" loans or products.

Always ask your loan officer if they offer portfolio loans. If not, tell them what you're looking for. And they can look for an investor who's amenable to your terms.

Q: Why does a 7/1 ARM mortgage have a lower rate than a 5/1 ARM?

A: In general, longer term fixed rates will be higher than lower term fixed rates. A longer fixed rate benefits the borrower and the bank has less opportunity to adjust the interest rate and make money.

However, there are instances where this may not be the case:

  • The mortgage company is pushing one product over another
  • When comparing mortgage companies, they don't all have the same cost or margin for borrowing money
  • Make sure you're comparing apples to apples. It's too easy to compare loans that don't have the exact same terms.