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Adjustable Rate Mortgage Components | How ARMs Work

Adjustable Rate Mortgage Components

Adjustable Rate Mortgage Components are composed of a number of factors which determine the interest rate that you will pay on the balance of your mortgage loan.

Frequency of Changes

The frequency of rate changes for an ARM loan depends on the terms.  The product name usually indicates the frequency of rate changes.  For example, a 3/1 ARM means that the rate is set for the first three years and cannot go up or down.  After those first three years, the rate adjusts every year.  The same would be true of a 5/1 ARM with the first five years set and the rate adjusting every year after.  Because there are numerous variations of ARM loans, it is not possible to cover every one in existence.

Interest Rate Change Caps

Most of today’s ARM loans contain provisions known as “caps”.  These caps place maximum limits on the amount rates can change.  This takes some of the risk out of having an adjustable rate loan and often makes the product more attractive to the consumer.

Interest Rate Caps

Interest rate caps do just as the name describes: place limits on how high the interest rate on an ARM may ever be.  This is of great importance to the borrower because the interest rate can never go above the worst-case scenario.

Rate Adjustment Caps

A rate adjustment cap focuses on the amount the interest rate is allowed to change from one adjustment period to the next.  The interest rate cap on a loan may be 9.5% for the life of the loan, but it may only be allowed to adjust—up or down—2% between two adjustment periods.

Life of Loan Caps

A life of the loan cap sets the maximum the interest rate may go above the initial rate over the entire life of the loan.

Whenever there is a cap on an ARM loan, it serves to modify the formula used to calculate the interest rate.   The existence of caps is utilized in the worst-case scenario analysis that really allows the borrower to assess what the payment would be like if the ARM rate went to the ceiling.  However, this may not give the borrower the most accurate information because when a cap is in place, the interest rate change is determined by one of the following methods, depending on which one yields the smallest charge:

INDEX + MARGIN

or

RATE + CAP

(Whichever charge is smaller)

Initial Adjustment Cap

Particularly in programs where the initial interest rate is set for a longer period of time, the transitional cap—when the first rate change occurs—may be different from the caps addressed as the loan adjusts annually thereafter.  The rate may be allowed to increase to the lifetime cap after the initial adjustment, and subsequent adjustments may be based upon that new rate.  These caps are sometimes written as 5/2/5.  This must be investigated because, due to borrower concerns about the frequency of changes, the change caps may be overlooked as an unimportant factor.

Payment Caps

Payment caps dictate the rate at which the borrower is allowed to make payments, not the interest rate.  Payment capped ARM loans may allow for an increase in interest rates almost immediately following the initial rate.  This may cause the capped payment to be insufficient to cover the new total for interest due.  This failure to cover the interest results in a shortfall, known as negative amortization.  If the borrower chooses to make the minimum payment or something less than the full interest due the shortfall in payments is added to the principal balance of the loan.

The Index

Two factors determine how often the rate can change.  Both the frequency of payment and rate adjustments figure into just how often the rate changes.  Thus, the interest rate changes are a function of the index added to the margin.  Using the index determines the future rate changes of an ARM.  The borrower should look for the index to:

  • Be regularly published in a source accessible to the public
  • Be beyond the lender’s control.  If the index is linked to the lender’s performance, or risk experience, the lender could theoretically increase the index whenever they needed to make more money.  This may have happened with LIBOR.

Numerous indices are used to determine how interest rates can change on adjustable-rate mortgages.  Some of the more common and popular indices and how often they adjust can be found in the table below:

 

Index Adjusted Definition
LIBOR: London Interbank Offered Rate One month, six months, 12 months (depending on loan program) Average interest rate charged to banks in the London Interbank System when borrowing money from one another with ranging maturities
COFI: 11th District Cost of Funds Index Monthly/Once a year (depending on loan program) Weighted index of the cost member banks (in Arizona, California, and Nevada) pay on money borrowed such as customer checking and savings accounts
COSI: Cost of Savings Index Monthly A stable index that is the weighted average of interest rates on deposit accounts (savings) at federally insured depository institutions
CMT: Constant Maturity Treasury Once a year Follow the weekly or monthly fluctuations in the yield on one-year Treasury bills
MAT/MTA: 12-Month Treasury Average Monthly Average yield on U.S. constant-maturity one-year Treasury bill adjusted every month by the U.S. Treasury that reacts slowly to short-term fluctuations
Prime Rate: The Fed (U.S.) Prime Rate Various Short term interest rate used in the banking system of the United States used by various lending institutions and is the basis for rates on most short-term loans/lending instruments (Fed Funds Target Rate + 3)

 

The index is one component used when figuring the new rate of an adjustable-rate mortgage loan.  The other key piece that must be factored in when figuring the new rate is the margin (discussed below).  Using the two variables, the new rate is determined by the following equation:

INDEX + MARGIN = NEW RATE

The variables of each index are a factor in analyzing the future performance of an adjustable-rate mortgage.  For instance, if the index is stable, future interest rate increases may not be dramatic, but there is less likelihood for an improvement in the event of future interest rate decreases.

The Margin

The margin is set by the lender and is the amount above the index that the interest rate can adjust at the time of adjustment.  The result of the index plus margin formula is the new interest rate.

This represents the real interest rate of an ARM.  Considering the real cost is important because it goes beyond the discounted rates that are offered on most ARM loans, especially those ARMs that are short-term.  A discounted rate indicates that the points paid in conjunction with the loan artificially reduce the initial interest rate to attract borrowers.  Looking at the equation that uses the index plus the margin gives what is known as the Fully Indexed Accrual Rate (FIAR).  This gives a more accurate representation of the actual costs of the loan, rather than simply using the discounted rate.

The Lowest Margin Offers the Lowest Cost

                                      Loan 1                  Loan 2

Initial Rate                      5.500%                  5.500%

Index                             4.875%                  4.875%

Margin                           2.500%                  3.750%

New Rate                       7.375%                   8.625%

 

Every loan may offer a different margin.  This is a critical part of analyzing the ARM.  In the above example, all things are equal, except the margin.  The margin is higher on Loan 2, which means that the FIAR, or the true rate of the loan, is higher on the second loan.  This means that, regardless of what happens to interest rates, the customer who chooses Loan 2 will pay a higher interest rate over the life of the loan.  This is true of any ARM.

 

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