Mortgage Lending is complex and all aspects are detailed and can be very confusing. Let's discuss the details of an Adjustable Rate Loan (ARM) because it is evident that there is still some question about consumers understanding the whole truth about ARMs. Why? I think it is because some may have been told that their loan is fixed for the initial period of 3, 5, and 10 years and then it becomes an Adjustable Rate Loan. They fix their mind on the 3, 5, and 10 year period. Fixed Rate Loans are just that. The rate is set for the life of the loan. Nothing compared to the ARM loan
Well, yes it is true, the loan is fixed for the initial period specified but it is still called a 3/1, 5/1, or 10 year ARM loan and it will fluctuate after the initial period. But, there are also other ARM loans which will adjust in 6 months (6 mo LIBOR ARM) and every 6 months following. Then you have the 1 year ARM, which is fixed for the first year and then will adjust according to the terms on your note. The 3, 5, and 10 year ARMS can be good for borrowers who do not plan to stay in their home over and above the initial period of time. If you are looking at the ARM loan features mentioned above; less than 3 year, 5 years or 10 years. It can also be a frustrating event to someone whose interest rate jumps significantly without a salary increase.
Let's look at how ARM loan features and how they are determined. The rate is based upon the Index and Margin. The index is based upon the ARM type it is. These Index are:
Interbank Offered Rate (LIBOR) London
- 12-month Treasury Average Index (MTA)
- 11th District Cost of Funds Index (COFI)
- Constant Maturity Treasury (CMT)
- National Average Contract Mortgage Rate
These can be broken down drastically into something like this:
- 1 yr Treasury CMT Monthly
- 1 yr Treasury CMT Weekly Average
- 2 yr Treasury CMT Note Monthly Average
- 2 yr Treasury CMT Note Weekly Average
- 3 yr Treasury CMT Note Monthly Average
- 3 yr Treasury CMT Note Weekly Average
- 5 yr Treasury CMT Note Monthly Average
- 5 yr Treasury CMT Note Weekly Average
- 10 yr Treasury CMT Note Monthly Average
- 10 yr Treasury CMT Note Weekly Average
- 6 mo Auction (Disc Rate)Constant
- 6 mo Auction (Disc Rate) Monthly Average
- 6 mo Auction (Disc Rate) Weekly Average
- 11th District FHLB (Federal Home Loan Bank) Cost of Funds
- Average COF to FSLIC Insured S &L
- FHLBB 1 Yr National Contract Rate
- Institution's Cost of Funds
- National Monthly Median COF FHLBB
- National Average Contract
- Prime Rate
- Wall Street Journal Prime
This is a long list but this just to show you that an ARM (Adjustable Rate Loan) is not something that is all that simple. Because there are so many Indexes and the way they work are all different in most cases with some being minor differences.
If you are offered a 1 year ARM, this means that your rate will be fixed for 1 year and then it will convert to a rate that will fluctuate/increase or decrease over the life of the loan. Unless of course the ARM allows for converting to a fixed rate loan. There are caps that are applied for the first adjustment date for the interest rate. There are life of loan caps which will tell you how much the rate can increase over the life of the loan. For the1 yr T Bill ARM; it usually goes something like this: The initial interest rate is based upon the margin, which usually ranges from 2.25 â€“ 3.00 percent, give or take + index and unless you are looking at the index that is published for that particular day; you do not know what that figure is until the loan is locked. Your first rate adjustment will be month 11 and the payment will increase or decrease depending upon the rates at that time. You will have a rate cap for the first adjustment of probably 2.000 percentage point. Often the note will express the maximum (life of loan cap/rate) at 12.75% or it may indicate a percentage point of 5% over the initial fully indexed rate. These figures are only examples.
1 Year Treasure Bill
Example: Index 2.75% + Margin 2.00 = Rate of 4.75% = Fully Indexed Rate.
I have only estimated the Margin and Index and used lower because the Index rates are lower at this time. But when your loan begins to adjust; it will depend upon if the economy has adjusted upward. Usually when the economy is not good the interest rates are lower. When the economy gets better the rates will go up. Sounds like it should be just the opposite, but it isn't. So, your rate could go up significantly if the economy were to change drastically for the better; at the moment, it is not likely.
Your cap the first period as stated above could be around 2% points up and a rate not less than the initial rate of 4.75%. Usually that is how the mortgage note will state it and the rate is usually rounded by .125%.
Margin -- the fixed component of your ARM loan, the same through out the term of your loan
Index -- the variable component of you ARM loan, changes based upon the Index that applies to your specific ARM loan. The indices are list above for your convenience.
Fully Indexed Rate-- the rate you pay not including any periodic caps, in order to fully amortize or pay off the loan.
Lifetime Cap â€“ the maximum rate that your adjustable rate loan an increase over the life of the loanâ€¦full term.
Periodic Cap - the maximum percentage point that your rate can increase or decrease on each change date. In other wordsâ€¦1 % or 2% etc. It will be listed on your note.
Floor Rate â€“ the minimum rate of interest that your rate will ever be and most of the time; it is the initial interest rate of the loan.
Payment Cap â€“ applies to loans which have the potential for negative amortization and gives the maximum percentage the payment can increase for change date or period of time.
First Change Date Rate Change: this is the first adjustment date for the loan. These are sometimes very different from the periodic cap. You should know all of these terms and what applies to your loan specifically as different indexes have different features and caps.
Please note it is not possible for me to give you the entire specifics of all ARM loans in one articles. But, I am giving you questions you should get answers to. Even if you think you are educated about ARM loans. Never assume anything because these loans can be tricky but useful to some consumers for saving interest upfront and lower payments if the house will be sold in a short period of time.
Here are the things to ponder and questions to ask:
- What is the initial interest rate
- How much can my rate increase or decrease on the first adjustment date
- When is my first interest rate adjustment date *the payment will adjust 1 month following the change of interest by most standards
- How frequently will my rate change *beware of 6 month LIBOR ARMs ; these loan rate change every 6 months
- What are the caps for my interest rate, after the first change date
- How much can this rate increase over the life of the loan
- What is the Floor rate of this loan (minimum rate)
- What is the Index and Margin *remember the margin will remain the same for the life of the loan, the Index will not but they can only give you the initial Index Rate or they should.
- Can I convert this ARM loan to a fixed rate *this is called a conversion option
You should receive an Adjustable Rate Loan Disclosure; it will explain to you how the loan that you have been offered works.