Adjustable Rate Mortgage Loans (ARM's)
An adjustable rate mortgage (also called variable rate mortgage) is a mortgage where the interest rate on the loan is periodically adjusted. The rate is based on an underlying index and adjusts as that index is changed. Consequently, payments made by the borrower change over time as the interest rate changes. Adjustable rates transfer part of the interest rate risk from the lender to the borrower. The borrower benefits if the interest rate falls and loses out if interest rates rise.
All adjustable rate mortgages tie their interest rate to an index. Some common indices are:
- 11th District Cost of Funds Index (COFI)
- London Interbank Offered Rate (LIBOR)
- 12-month Treasury Average Index (MTA)
- Constant Maturity Treasury (CMT)
- National Average Contract Mortgage Rate
The index may be applied directly, on a "rate plus margin" basis, or based on index movement.
A directly applied index means that the interest rate on the loan changes exactly with the change in the index.
A rate plus margin means that the interest rate will equal the underlying index rate plus a margin. For example, a mortgage interest rate may be specified in the note as being MTA plus 2%, 2% being the margin and MTA being the index.
An index movement basis means that the mortgage is originated at an agreed upon rate, then adjusted based on the movement of the index.
Interest rate caps -limitations on charges- are a common feature of adjustable rate mortgages. Caps typically apply to mortgages in three ways:
- Cap how frequently the rate can change (ex: Adjustments may be made only once per year)
- Cap the amount the rate can change in specific periods (ex: Interest may only adjust by maximum of 1% every 12 months)
- Cap the total change in interest rate over the life of the loan (ex: Interest rate may only be adjusted a maximum of 5% in the lifetime of the loan)
Notes on Caps
- Mortgages may have different adjustment caps depending on the period (first year at 2% max, fifth year at 3% max, etc.)
- Rather than cap the interest rate, some mortgages may cap the total monthly payment in absolute terms. For example, a monthly payment may be capped at $1000. Beware of these mortgages though as a borrower may find that they end up paying nothing but interest on the loan.
- Cap structure is sometimes expressed as initial adjustment cap / subsequent adjustment cap / life cap. For example 1/2/6 for a mortgage loan would mean a 1% cap on the initial rate adjustment, a 2% cap on subsequent rate adjustments, and a 6% cap on total lifetime interest rate adjustments.
Hybrid ARMs - A hybrid adjustable-rate mortgage (ARM) is a mortgage where the interest rate is fixed initially, then is adjustable at some point in the future. Example: A 3/1 ARM has a 3 year fixed period and a 1 year rate adjustment period thereafter. The date that a hybrid ARM shifts from a fixed-rate to an adjusting rate is known as the reset date.
Option ARMs - An "option ARM" is a loan where the borrower has the option each month of making either a specified minimum payment, an interest-only payment, or a full payment based on a fixed rate. The minimum payment is less than an interest-only payment and results in negative amortization. The full payment is fully amortized pays down both interest and principal. Option ARMs are popular because they are usually offered with a "teaser rate" (a very low initial interest rate) and a low minimum monthly payment. This permits borrowers to qualify for a larger loan than they would otherwise.
Start Rate - The ARM introductory rate for the initial fixed interest period.
Fully Indexed Rate - Index Rate + Margin = Fully Indexed Rate. This is the interest rate your loan would be at without a Start Rate (the introductory special rate for the initial fixed period).
Loan Margin - The difference between the mortgage loan rate and its underlying index (on which the note rate is based).
Floor - The minimum rate for the interest rate of an ARM loan. A floor prevents an ARM loan from ever adjusting lower.
Payment Shock - Term for the severe upward movement of mortgage loan interest rates and their effect on borrowers. This is the major risk of ARMs and can lead to unmanageable monthly payments and/or negative amortization.