Friday, December 15, 2006 - Article by: Lender411 Member
Adjustable rate mortgages (ARM) have completely dominated fixed-rate mortgages (FRM) recently. More and more people are choosing ARMs because they are generally 1-2 points lower than a FRM. This allows them to qualify to buy a more expensive house.
Let's get down to the basics of the adjustable rate mortgage (ARM). Most ARM's are now classified as "hybrid mortgages." A hybrid mortgage combines the features of both fixed-rate and adjustable-rate mortgages.
It starts out with an interest rate that is fixed for a period of years (usually 2, 3, 5, 7 or 10 years). At the end of this period of years, the loan converts to an ARM. At that point it adjusts and then will do so every six months or once per year depending on the program you choose.
It does this for 30 years. ARMs are still 30-year loans. The rate is just not FIXED for 30 years. It is adjustable.
A reminder....almost always, the shorter the term of the mortgage, the lower the rate. As a result, a mortgage fixed for 10 years has a lower rate than one fixed for 30, a 7 year fixed rate is lower than one fixed for 10, a 5 year fixed rate is lower than one for 7, a 3 year fixed rate is lower than one for 5, and so on.
Why is this? The shorter the term of your loan, the less risk it is to the lending bank.
Example: If the bank loans you money today, in 2005, at a fixed rate for the next 30 years at 5.875% and interest rates shoot to 8.000% five years from now, in 2010, they are stuck with your loan at 5.875%. Obviously this is not the best investment on their money in 2010. They made a commitment to you in 2005 and in 2010 it now is killing them. However, if you give them the ability to "correct" this or "adjust" this at some point, they can try and catch up to the market conditions at the time of the adjustment. This is beneficial to them so they reward you for lessening this risk by offering you a lower rate to allow them this flexibility at a later date.
OK, so on March 1, 2006, you sign your loan docs where you have elected to go with the 5 YR ARM at 5.25% vs. the 30 YR FIXED rate of 5.875%. The ARM you have chosen will adjust once yearly.
For the first five years your rate is going to be FIXED at 5.25%. Your rate can go no higher and can go no lower. For these 60 months, your payment will NOT change.
On March 1, 2011, your 5 YR ARM is going to adjust. It is going to adjust on this day and every March 1 thereafter for the next 25 years. Your rate is no longer guaranteed at 5.25%. It is now based on the
INDEX plus the MARGIN.
What are the index and margin?
This is where LIBOR, COFI, CODI, CMT, and MTA come in. These are the most popular of the indexes.
LIBOR - London InterBank Offering Rate is the average lending rates from a number of major banks based in London, England. It is commonly used as an international interest rate index. LIBOR is influenced by changes in both the Bank of England's official rate and the targeted fed funds rate.
COFI - Cost of Funds Index is a very stable index that is based on the average cost of deposits and borrowings for savings institutions in the Federal Home Loan Bank's 11th district (which consists of California, Arizona, and Nevada). Tends to lag behind changes in market interest rates.
CODI - Similar to COFI but it is based on Certificate of Deposits. Since it is based solely on deposits it responds more rapidly to changes in market interest rates than a COFI.
CMT - Constant Maturity Treasury Index is the weekly average yield on the United States Treasury securities adjusted to a constant maturity of 1 year. Since this index is a monthly average of the one-year CMT yield, it is less volatile than daily interest rate movements but more volatile than other indexes such as the COFI.
MTA - This is based on the same securities as the CMT but it is based on annual yields rather than weekly yields. As a moving average going back over the past year, it is more stable than an index base solely on current values.
Are you completely lost yet? It can be very confusing.
The LIBOR has become the Index of Choice in the last few years because it is comparatively low and has been pretty stable. It is also tied to the major banks of London, which means it is not directly tied to the U.S. economy. I would estimate that 70-80% of ARMs today use the LIBOR index.
OK, so it's March 1, 2011, you had a 5 YR LIBOR ARM, and you know it is going to adjust to whatever the LIBOR index is on that day. Let's say the LIBOR index is at 3.10 on March 1, 2011.
You now need to add in the margin. Let's say your margin is 2.25%.
The margin is what lenders add to the index rate to determine your new rate. The amount of the margin can differ from one lender to another and from program to program, but it is usually constant over the life of the loan. If your margin is 2.25% in the loan you signed on for on March 1, 2006, it will likely stay there for the next 30 years.
On March 1, 2011 you add the LIBOR index as it is on that day in 2011 of 3.10 and you add that to your margin, that will remain consistent, of 2.25% and your new rate on that date will be 5.35%.
On March 1, 2012, you will do this again. On March 1, 2013, you will do this again. This will happen every March 1 of every year until the 30 year loan is complete.
Most ARMs have a life cap. The rate cannot go over a certain cap over the life of the 30 tear loan. This cap is usually of 5 or 6 points ABOVE the start rate. If you started with a 3 YR ARM at 5.000% and the cap is 6, the bank can raise the rate no higher than to 11.000% over the life of the loan if necessary market conditions call for it. Even if rates were at 13.000%, your loan can go no higher than 11.000%.
Recent studies have shown that most homeowners either refinance or sell their home within 5 to 7 years. Therefore, most buyers who opt for a 7-year ARM will never even experience adjustable-rate payments.
Most ARMs also have yearly caps of usually 1 or 2. This means that the loan cannot go up any higher than 1 to 2 points in any 12 month period. If it started at 5.00%, even if the index + margin adjustment calls for it to go to 8.00% and the yearly cap is 2, it can go no higher than the 2 to 7.00% that year.
Most of these loans can also be done as interest-only for a fixed period of time. Choosing interest-only options does not change the way the ARM adjusts. Sometimes the interest-only period will even exceed the fixed period. Example: Some 5 YR ARMs allow for the interest-only option for the first 10 years.
Be very careful. Your payment will increase substantially when the interest-only period is over. If your rate has increased substantially because of adjustments you may now be in a house that you simply cannot afford. This is a topic for another time.
Before you choose the ARM that is right for you, first determine how long you want your loan to be fixed for, next find out what indexes your lender has that loan available in and then find out what the margin is on each. Just because the COFI is at 2.00 today and the LIBOR is at 3.00 does not necessarily mean that the COFI it is better for you. The margin may be higher on the COFI-based ARM and none of us can predict where any index will be five years from now on your five year ARM.
Many different websites can show you the history of each index. It is definitely worth consideration before choosing your ARM program.
Didn't find the answer you wanted? Ask one of your own.