An adjustable rate mortgage (ARM) is a mortgage loan with an interest rate that can change at the end of pre-determined intervals, such as every six months or every year. These changes in the interest rate are due to the published index that reflects the current interest rate. A widely used index is the interest imposed by the United States treasury bonds. If this index goes up, say at the end of the adjustment period, the mortgage rate will also go up. If it goes down, the mortgage rate will also go down. This will increase the borrower’s payment and the lender or borrower has no way in predicting if the index will go up or down.
Fixed-rate mortgages, on the other hand don’t depend on indexes or any other unstable factors. Adjustable rate mortgages actually transfers the risk that lenders have in fixed-rate mortgages to the borrower by having the flexibility to adjust the interest rate when indexes makes it viable for them to do so. Index rates are very unpredictable and can depend on a lot of factors. One must be very smart in entering into an adjustable rate mortgage and must do extensive research in determining the factors that will be beneficial to you. You need to learn to identify the basic elements of an adjustable rate mortgage in order for you to learn what you’re getting yourself into.
First, you have the initial interest rate, which is the beginning of the interest rate of an ARM. This is negotiated between you and the bank at the signing of the mortgage contract. The index rate is the published rates that can be found on treasury securities and loan associations. Interest rate cap is an important concept in ARM because it will regulate the limit or the increase in your interest rate.
They can either be (1) periodic adjustment caps which regulate the interest rate, whether it will go up or down on a certain adjustment period or (2) lifetime caps which limits the increase of the interest rate over the whole lifetime period of the mortgage loan. In periodic cap adjustments, suppose the borrower has an ARM with an adjustment rate of 2% but after the first adjustment the index has increased by 3%.
Using a graph, this is what your monthly payments would look like:
This graph shows 3 different mortgage payments for a $200,000 loan. The first year’s monthly payment at 6 percent is $1,199.10. The second year’s monthly payment at 9 percent, without a periodic adjustment cap, is $1,600.42. The second year’s monthly payment at 8 percent, with a periodic adjustment cap, is $1,461.72. The difference in the second year between the payment with the cap and the payment without the cap is $138.70 per month.
Here, with the help of your cap, in the second year your monthly payment will be $138.70 lower ($1,600.42 without cap minus $1,461. 72 you’ll be paying with cap equals $138.70 saved) so you get to save $1,664.40 a year.
Also, payment caps provide a limit or “caps” the amount that your monthly payment may rise due to the adjustment. For example, if the payment cap on your loan is 7 1/2%, your payment the next year will not be over 7 1/2% of what you paid the year before. So if your monthly payment in the first year of your loan is $1,000, it will not go over $1,075 the next year because of the caps.
It is important because it gives you a ceiling to expect the rise of your monthly payment. It also regulates how interest rates are imposed so as not to take advantage of the mortgagors. Here is what your monthly payments would look like:
This graph shows 3 different mortgage payments for a $200,000 loan. The first year’s monthly payment at 6 percent is $1,199.10. If the interest rate rose two percent to 8 percent in the second year but there was a seven and one-half percent payment cap, monthly payments in the second year would be $1,289.03. If the interest rate rose two percent to 8 percent but there was no payment cap, monthly payments in the second year would be $1,461.72. The difference in the monthly payments with and without the payment cap is $172.69.
There are different types of ARMS to suit the needs of all borrowers:
1. Hybrid ARMS
This type of adjustment rate mortgage is called hybrid because it has features of the fixed-percentage rate and the adjustment rate mortgage. For a period of time, the interest is fixed a certain amount and after such stipulated period, it functions like a regular ARM. It depends on the parties to fix the periods but some hybrid ARMS will feature a 2-year fixed interest-rate period and then a 1 year adjustment period. The reset date is what we call the period where it transitions from a fixed-period rate to an adjustment rate. After the reset date, the hybrid ARM functions more or less like a regular ARM.
2. Option ARMs
Also known as “pick-a-payment” or “pay option” ARMS, the borrower is given the option to choose from the following: an interest-only payment, a specified minimum payment, 15-year fully authorizing payment and a 30-year fully amortizing payment.
The Option ARMs however has the risk of negative amortization where you could end up paying more than you owe. Negative amortization happens when the outstanding obligation of your loan has not been paid and interest accrues to the amount. If you pay a minimum of $1, 000 and the interest has racked up to $1, 500, an additional $500 will be placed on your outstanding balance. On the next month, a higher interest will be calculated based on the higher principal. There are some lenders who place caps on negative amortization. Typically, the cap is not more than 110% to 125% of the original loan amount. You can also limit negative amortizations by increasing payments on your monthly amortizations.
Despite the risk of negative amortizations, adjustment rate mortgages allow borrowers to get a lower initial payment provided that they will assume the possibility of higher interest rates. Borrowers have to be cautious of ARMs and the offer of “teaser periods” which lures borrowers with low initial payment or short initial fixed-rate periods. The interest rate here is relatively low than the “indexed” rate. However, be careful of accepting this as a bargain because most likely, the payment increases will be above than average.
With an ARM, the borrower can reduce his initial interest rate and initial monthly payments on the duration of the loan by one or two percentage points. Advisers suggest that borrowers should carefully read their loan agreement to check any pitfalls and understand what might increase their interest rate. Clarence Lewis III, a mortgage broker (article by Aissatou Sidine, 2006), says that “borrowers should find out the volatility of the index used to calculate their loan’s mortgage rate, calculate the maximum possible adjustment in their monthly payments as their specific index rate climbs, and determine whether their budget can cover that hike. If your budget cannot handle the maximum allowed interest rate hike, an ARM is probably not for you”.
In the same article, Ed Powell, chief consumer officer and vice-president of Lendingtree.com says that if you have any plans of moving in one to two years, you should stay with your ARM payment versus converting to a fixed-rate loan. He explains that converting and paying closing costs–which will be about $2,000 for every $100,000 in mortgage costs–plus any additional conversion charges, would only save you money if you stayed in your home for the long term.
Last year, a lot of people fell into the Arm trap with lots of teasers, with the very low initial interest rates. In an article in Newsday by Tami Luhby, many borrowers needed to keep their homes and had no choice but to choose the mortgage with the lowest interest rate. Borrowers like Clejan, knows that in five years, the outstanding amount would massively increased. With the real estate crisis in the US, the problem will only get worse especially since almost 2 million ARMS will rest this year.
Advisers also suggest that before panicking, check to make sure if your mortgage is an ARM. If it is, consult a financial professional or even a lawyer to review your contract and give you a projected amount on the possible interest rate increase in the coming months or years. If you found out that your payment will be more than what you can afford, budget your finances as early as right now. You can also consider refinancing or transferring over to a fixed-rate loan or a hybrid ARM. Afterwards, talk to your mortgagor to discuss your options and look around for other lenders who can offer the best refinancing scheme. You can also call a nonprofit Credit Counseling Service to help you out.
What People are Saying: The Good and Bad With ARM
In Sidime’s (2006) article, a US Army Captain, Samuel Williams and his wife chose a two-year adjustable mortgage over a fixed-rate mortgage and built a five-bedroom, two-storey home in San Antonio. The couple stated that without the ARM, they would have purchased a house that did not meet their needs. The flexibility of the ARM enabled them to build their dream house instead.
Another article by Christine Williamson cites the advantageous use of ARM by hedge fund managers. Mr. Louis Moore Bacon purchased the Trinchera Ranch which has views of the tallest and loveliest peaks in the Colorado Rockies. Mr. Bacon is very much happy with the purchase showing that there is still a strong market for luxury properties in the US.
However, a lot of people are very unhappy with their ARMS and plan to refinance using a fixed-rate mortgage. The Dallas Morning News (2006) reported the case of Kraus and her husband who had to refinance with a fixed-rate loan. Kraus said that when the interest rates started going up, it impacted them a great deal. More and more people are going back to the old-fashioned fixed rate system. Amy Crews Cutts (2006), a deputy chief economist for Freddie Mac stated that many Americans took out ARMs with the hope that interest rate would stay low for many years, however, it just started coming back up strong in the following months in 2006.
Whatever good and bad that ARM brings, in the end, it should depend largely on the borrower who should be very smart when it comes to mortgaging payment options. Research and study should preempt any mortgage decisions so that you can know the ins and outs of your situation and be ready for any surprises that may come. Intelligent borrowing will end happily, with your home intact and your family debt-free.