There are two primary types of mortgages, a fixed rate loan and an adjustable rate loan. Both have been staples of the mortgage industry for decades but the adjustable rate mortgage, sometimes referred to as an “ARM” has been in place much longer.
Those in the lending industry can throw them around on occasion not realizing that the consumer may not be as knowledgeable with the inner workings of an ARM. We’re here to make sense of it all.
A fixed rate loan is easy to figure out. The interest rate is fixed throughout the life of the loan; it never changes. An adjustable rate mortgage can in fact change but only under specific circumstances, detailed in the loan paperwork.
The most important thing to understand about ARMs is how and when their interest rates can change. An ARM’s rate is determined by:
- Its initial fixed period
- Its index
- Its margin
- Its caps
The Initial Fixed Period
Most ARMs are fixed for a certain amount of time to begin with. For example, a 3 year ARM is fixed for 3 years, then starts adjusting.
You may have heard of a 3/1, 5/1 or 7/1 ARM. This simply means the loan is fixed for 3, 5 or 7 years, then adjusts once per year (hence the “1”).
The shorter the initial fixed period, the lower the initial rate.
This is where consumers must be careful. When hearing about a “fixed” loan that has a rate that’s too good to be true, rest assured that it is. A supposed 2% “fixed” rate is most likely a 3 or 5 year ARM that’s fixed initially but can then adjust to current rates thereafter. Make sure you read the fine print on advertisements and especially your loan documents.
The ARM Index
After the initial fixed period is over, the ARM interest rate can adjust. You’ll want to know how much it can adjust, and the index plays a big part of that.
The index is based on current financial instruments. Most indeces these days are based on the 1 year LIBOR or the Constant Maturity Treasury Rate, referred to as the CMT.
Regardless of the specific index, ARMs operate in a similar manner. The index is the starting point for calculating a new rate.
Indices fluctuate up and down, and your adjusting ARM rate will follow suit. Before you agree to an ARM, check on how high the index has gone in the past. It may be headed back in that direction.
The ARM Margin
But the index is not the whole story.
A margin is added to the index to come to your total interest rate. Typical margins range anywhere from 2.00 to 2.50 percent.
Where does the margin come from? Quite simply, from the bank. The margin is the bank’s profit. It’s the amount above and beyond the current lending rates of the day (the index) that the bank collects to make your loan profitable for them. The bank determines how much they want to make on your ARM loan after it starts adjusting.
The Index plus Margin
Let’s now say an adjustable rate mortgage is at the end of its fixed period and is about to adjust. The index is the 1 year LIBOR and the margin is 2.25 percent. If the LIBOR today were 0.75 percent and the margin 2.25, the new ARM rate is 0.75 + 2.25 = 3.00 percent. Not too shabby, at least in today’s ultra low interest rate environment.
But ARM interest rates can get a whole lot uglier in a high interest rate environment. That’s why there are ARM caps.
The ARM Caps
The final component of your ARM interest rate are the caps applied to the loan. There are three primary types of caps: an initial cap, recurring cap and lifetime cap. A cap is a consumer protection tool that prevents an interest rate from wild, volatile swings or ultra-high rates.
Now let’s say that an ARM loan with an initial rate of 3.5% is adjusting for the first time tomorrow. The LIBOR index shot up to 10.00 % during the fixed period. The margin is 2.50%. What would the new rate be?
At first glance, you may think the rate will rise from 3.5% to 12.5% overnight. Luckily, the caps will kick in and do their job.
Let’s imagine this same loan has 2/2/5 caps. This means the interest rate can rise a maximium of 2% the first year, 2% each subsequent year, and a maximum of 5% over the life of the loan.
The first year, the ARM in this example will rise from 3.5% to 5.5%, which reflects the maximum 2% increase the first year (2/2/5).
The second year after the initial adjustment, the ARM will rise to 7.5%, assuming the LIBOR index is still at 10%.
The third year, still assuming a 10% index, the rate should rise to 9.5%, because the rate is allowed to rise 2% per year (2/2/5). But, it will only rise to 8.5% – 5% above the initial fixed period rate (2/2/5). The 5% “lifetime cap” as it’s called, has protected the borrower from the 9.5% interest rate, or the 12.5% interest rate that it would be without any caps at all.
In this way, ARM loans may not be as scary as they first appear, assuming a low lifetime cap is paired with a low initial interest rate.
For example, if you get a 2.5% initial fixed period rate, and a 5% lifetime cap, your loan can never go above 7.5%. Not a low final rate, but not the end of the world.
Just make sure you can afford the highest possible rate to which the ARM can rise.
Still have questions? Contact one of our reputable loan officers. Check back soon for our next post which will talk about when it’s a good idea to get an ARM.