Adjustable Rate Mortgages
Unlike a fixed rate mortgage, where the interest rate cannot change over the entire term of the loan, an adjustable rate mortgage (ARM) does not guaranty an interest rate.
Adjustable rate mortgages were effectively introduced in the United States approximately 25 years ago. Interest rates at that time were extraordinarily high. The prime lending rate was in excess of 20%, the 30 year government bond rate was approaching 20% and a very good 30 year fixed interest rate was 16.25%. This last rate made it very, very difficult for prospective home buyers to qualify for mortgages. Hence, the introduction of adjustable rate mortgages in the United States.
The primary reason that ARMs achieved some degree of popularity in the U.S. at that time is essentially the same reason they are still around today. That is, ARMs typically have a low introductory rate or start rate, often referred to as a “teaser rate”. These teaser rates can be 4% -5% below competing fixed rate mortgages.
The following are terms that will help you improve your ability to evaluate the pros and cons specific to you:
This is the rate that gets the attention of a potential borrower. You may see the advertised rate as low as 1.00%. This is certainly low enough in any market to grab the attention of a borrower! However, remember: a teaser rate is typically good for only 1 to 12 months. The lower the teaser rate, the shorter period of time until the first interest rate adjustment.
The index is the anchor point in the determination of an ARM’s interest rate. It is the component of the rate that creates the variable interest nature of an ARM... indexes move up or down depending on what is happening in the general and sometime specific financial markets. While there are many indexes available for use, some of the more common indexes are:
- LIBOR (London Inter-Bank Offered Rate)
- 11th District Cost of Funds
- 1 Year Treasury Bills
The margin represents the fixed component of an ARM. It is the spread over and above the index value that compensates the lender for any and all risks associated with making an adjustable rate mortgage to a borrower. Oftentimes downplayed, this is a very significant component of an ARM. In most cases, it can range from a low of under 2.00% to well above 3.00%.
Caps are protective devices that are incorporated into ARMs and help to minimize the borrower’s exposure to rapidly increasing interest rates. They are often communicated to borrowers in the following format: 2/6. This means that there is a limit as to how high an interest rate can be adjusted during each adjustment period as well as over the life of the loan. To illustrate this, let’s assume that a borrower received a one year ARM with an initial teaser rate of 4.00%... a 2/6 cap means that after the first year, when the interest rate is adjusted, it cannot exceed 6.00% (teaser rate of 4.00% plus annual cap of 2.00%) and under no circumstances could the interest rate ever exceed 10.00% (teaser rate of 4.00% plus lifetime cap of 6.00%).
Here are some very general adjantages and disadvantages of Adjustable Rate Mortgages:
- Teaser rate
- Ability to minimize cash outflow for mortgage payment
- Qualify for larger loan amount
- Uncertainty of future rates
- Costs associated with securing the loan
- Prepayment penalties
- Potential for negative amortization
- Not understanding your loan
While there are many individuals and institutions that tout ARMs as a better mortgage alternative than a traditional fixed rate mortgage, you should bear in mind that most of these individuals and institutions sell or aggressively promote these types of mortgages and very often do not even offer alternative mortgages. Their claims are generally related to the theory that, over the long term, the average interest rate for ARMs is lower than that of fixed rate mortgages. You will see in their promotional materials historical data that clearly supports their claim that these average rates are in fact lower than competitive fixed rate mortgages. However, you should be aware that, given enough historical data on indexes used in ARMS, time periods can be selected that can make averages look better than perhaps they should.
Think about this: if ARMs were as good as their promoters claim, would fixed rate mortgages even exist today?