The Adjustable Rate Mortgage does not seem to be very attractive to borrowers mostly because of the apparent complexity of its mechanism. When people hear about market indexes, constantly increasing rates and negative amortization, they don’t want to listen to this any more and just go for the good old Fixed Rate Mortgage. Before you follow their easy steps too, consider reading at least this article and make your final choice based on some knowledge, not on the lack of any desire to deal with anything more complicated than a fixed amount to pay every month.
Now, get yourself a cup of good coffee and prepare to learn about market indexes, increasing interest rates and negative amortization.
What’s the most important thing to remember about the Adjustable Rate Mortgage? Well, naturally, that the Interest Rate gets adjusted a number of times within the life of the mortgage, but – now comes the most important thing – it can increase (or decrease) only to the limit specified in your mortgage contract! That means that the lender is not totally free to impose any rate on you any time of the day. That’s the good news. The bad news is, however, that any Adjustable Rate Mortgage is dependant of the free market economy. Specifically, the Interest Rate is determined by one of the several market-related indexes:
- the one-year, three-year and ten-year Treasury bill rates;
- the Eleventh District Federal Home Loan Bank cost of funds;
- the national average contract interest rate on conventional home loans;
- the national median cost of funds to federally insured savings institutions;
- the new CD-ARMs by Fannie Mae tied to the average certificate of deposit interest rate; and
- the London Interbank (LIBOR) interest rates.
There are a lot more of them, but these are the most frequently used ones. If you go for an Adjustable Rate Mortgage you’ll have to select one index to tie your mortgage to. The Interest Rate of your mortgage will be derived from the Rate of the index on the day closest to the adjustment day. You may find it quite useful to study the history of the indexes’ dynamics before you decide on the one to base your mortgage upon. The data is widely available in papers and on the Web. Fannie Mae requires that the frequency of rate changes should match the index selected. Thus, the one-year Treasury index is used to adjust the one-year Adjustable Rate Mortgage, while the three-year Treasury index is used to vary the three-year adjustable loan.
Why am I not saying that your Interest Rate will be the same as the index? That’s because it won’t. Lenders have a nice consolation prize for themselves – the margin. The margins usually vary between 1.5 and 3 percentage points, and give the lender a chance to add another, say, 2% to the rate of the index. And that’s how the actual Interest Rate of your mortgage is calculated on each adjustment.
Now, some more good news is that there is a variety of protective features that you can include into your mortgage contract to make sure, that the Interest on your loan should stay within the boundaries of reason.
First of all, the initial interest rate on an Adjustable Rate Mortgage is usually considerably lower than on a Fixed Rate Mortgage. This rate usually holds for some time – the Initial Fixed Rate Phase. This period can last from one month to several years. The longer the period – the higher the initial rate.
Then the adjustment day comes. Adjustments take place as often as specified in the mortgage contract. After the initial period of a fixed rate – say, 5 years – there usually are annual adjustments. 25 years of constant interest increase may sound very scary if you have a 30-year mortgage. To avoid turning your Adjustable Rate Mortgage into a golden Adjustable Rate Mortgage, the following limitations can be included into your contract – the Interest Rate Cap and the Payment Cap.
The Interest Rate Caps can be of two types: limiting the period increase (or decrease) of the Rate and limiting the overall life-of-the-loan Rate increase (decrease). You can include one of them or both into your contract. The period rate caps vary from lender to lender and usually range from 1 to 2 percentage points. The overall rate cap is usually 6%. The overall rate cap can be represented in the contract as the maximum allowed increase of the initial rate or as an absolute value – the percent, above which the Interest Rate cannot go.
The Payment Cap is a little bit tricky. On the one hand it ensures that the lender will not demand an unreasonably high period payment, which is good. On the other hand, under certain circumstances, it can bring you to face the unpleasantness of negative amortization of the loan. These are the issues to keep in mind:
- Some Adjustable Rate Mortgages set the initial payment below the interest payment. For 5 years you may enjoy quite low period payments that, in fact, do not cover even the period Interest costs. Every underpaid penny adds to the balance of the loan, i.e. generates negative amortization. When the Fixed Rate period is over, you realize that your debt has actually increased!
- It may so happen that Rate Adjustments will be more frequent than Payment Adjustments. The Rate increased, you won’t be able to increase your payments to match it until the next allowed payment adjustment. All the period in between these two adjustments the underpayments add to the balance.
- Payment adjustment caps limit the size of the change in payment, regardless of the size of the change in Rate. Any large rate increase will result in negative amortization.
In general, I believe, that Interest Caps are a lot more sensible for a borrower than Payment Caps. One thing for sure – Interest Caps do not amortize your loan negatively!
And the last (but not least) thing to remember – most Adjustable Rate loans do not need to include a prepayment penalty. Without this penalty, a borrower can more easily refinance to a Fixed Rate Mortgage. Some lenders also include a convertible loan feature that allows an Adjustable Rate Mortgage to be changed to a Fixed Rate Mortgage after the initial adjustment periods have been completed.
A comprehensive ARM calculator can be downloaded from here.
