Adjustable-Rate Mortgage (ARM) is a mortgage on which the interest rate can be changed by the lender. While ARM contracts in many countries abroad allow rate changes at the lender’s discretion, in the United States the rate changes on ARMs are mechanical. They are based on changes in an interest rate index over which the lender has no control. Henceforth, all references are to such Indexed ARMs.
Reasons for Selecting an Adjustable-Rate Mortgage (ARM)
Borrowers may select an ARM in preference to a fixed-rate mortgage (FRM) for three reasons, which are not mutually exclusive:
- They need the low initial payment on an ARM to qualify for the loan they want.
- They want the low initial rates and payments on ARMs because they expect to be out of their house before the initial rate period ends.
- They expect that they will pay less on the ARM over the life of the loan and are prepared to take the risk that rising interest rates will cause them to pay more.
How the Interest Rate on an ARM Is Determined
There are two phases in the life of an ARM. During the first phase, the interest rate is fixed, just as it is on an FRM. The difference is that on an FRM the rate is fixed for the term of the loan, whereas on an ARM it is fixed for a shorter period. The period ranges from a month to 10 years.
At the end of the initial rate period, the ARM rate is adjusted. The adjustment rule is that the new rate will equal the most recent value of a specified interest rate index plus a margin. For example, if the index is 5% when the initial rate period ends, and the margin is 2.75%, the new rate will be 7.75%. The rule, however, is subject to two conditions:
- Condition-1: The increase from the previous rate cannot exceed any rate adjustment cap specified in the ARM contract. An adjustment cap, usually 1 or 2% but ranging in some cases up to 5%, limits the size of any interest rate change. The new rate cannot exceed the contractual maximum rate. Maximum rates are usually five or six percentage points above the initial rate.
- Condition-2: During the second phase of an ARM’s life, the interest rate is adjusted periodically. This period may be but usually is not the same as the initial rate period. For example, an ARM with an initial rate period of 5 years might adjust annually or monthly after the 5-year period ends.
What is Quoted Interest Rate in ARM?
It is the rate that is quoted on an ARM, by the media and by loan providers, is the initial rate—regardless of how long that rate lasts.
When the initial rate period is short, the quoted rate is a poor indication of interest cost to the borrower. The only significance of the initial rate on a monthly ARM, for example, is that this rate may be used to calculate the initial payment.
What is Fully Indexed Rate?
The index plus margin is called the “fully indexed rate,” or FIR. The FIR based on the most recent value of the index at the time the loan is taken out indicates where the ARM rate may go when the initial rate period ends. If the index rate does not change, the FIR will become the ARM rate.
Assume the initial rate is 4% for one year, the fully indexed rate is 7%, and the rate adjusts every year subject to a 1% rate increase cap. If the index value remains the same, the 7% FIR will be reached at the end of the third year. The FIR is thus an important piece of information, the more so the shorter the initial rate period.
Nevertheless, it is not a mandated disclosure, and loan officers may not have it. They will know the margin and the specific index, however, and the most recent value of the index can be found on the Internet, as explained below.
What is ARM Rate Indexes?
Every ARM is tied to an interest rate index. An index has three relevant features:
All the common ARM indexes are readily available from a published source, with the exception of one called the Cost of Savings Index, or COSI, which is no longer offered on new loans.
In principle, a lower index is better for a borrower than a higher one. However, lenders take account of different index levels in setting the margin. A 3% index with a 2% margin provides the same FIR as a 2% index with a 3% margin. Assuming volatility is the same, there is nothing to choose between them.
An index that is relatively stable is better for the borrower than one that is volatile. The stable index will increase less in a rising rate environment. While it will also decline less in a declining-rate environment, borrowers can take advantage of declining rates by refinancing.
The most stable of the more widely used rate indexes is the 11th District Cost of Funds Index, referred to as COFI. Most of the others are significantly more volatile. These include the Treasury series of constant (1-, 2-, or 3-year) maturity, 1-month, 6-month, and 12-month LIBOR, 6-month CDs, and the prime rate.
Another series known as MTA is a 12-month moving average of the 1-year Treasury constant maturity series. MTA is a little more volatile than COFI but less volatile than the other series.
An ARM should never be selected based on the index alone. That would be like buying a car based on the tires. But if an overall evaluation (see below) indicates that two ARMs are very close, preference could be given to the one with the more attractive index.
How the Monthly Payment on an Adjustable-Rate Mortgage Is Determined
ARMs fall into two major groups that differ in the way in which the monthly payment of principal and interest is determined: fully amortizing ARMs and negative amortization ARMs.
Fully amortizing ARMs adjust the monthly payment to be fully amortizing whenever the interest rate changes. The new payment will pay off the loan over the period remaining to term if the interest rate stays the same.
A $100,000 30-year ARM has an initial rate of 5%, which holds for 5 years, after which the rate is adjusted every year. (This is referred to as a “5/1 ARM.”) The payment of $536.83 for the first 5 years would pay off the loan if the rate stayed at 5%. In month 61, the rate might increase to, say, 7%. A new payment of $649.03 is then calculated, at 7% and 25 years, which would pay off the loan if the rate stayed at 7%. As the rate changes each year thereafter, a new payment is calculated that would pay off the loan over the remaining period if that rate continued.
Negative amortization ARMs allow payments that don’t fully cover the interest. They have one or more of the following features:
- Payment Rate Below the Interest Rate – The payment rate, which is the interest rate used to calculate the payment, may be below the actual interest rate. If the payment rate is so low that the initial payment does not cover the interest, the result will be negative amortization.
- More Frequent Rate Adjustments Than Payment Adjustments – If, e.g., the rate adjusts every month but the payment adjusts every year, a large rate increase within the year will lead to negative amortization.
- Payment Adjustment Caps – If a rate change is large and a payment adjustment cap limits the size of a change in payment, the result will be negative amortization.
Virtually all ARMs are designed to fully amortize over their term. This means that negative amortization can only be temporary and that at some point or points in the ARM’s life history the monthly payment must become fully amortizing.
Two contract provisions are used to assure that negative amortization ARMs pay off at term:
- A recast clause requires that periodically, usually every 5 years, the payment must be adjusted to the fully amortizing level.
- A negative amortization cap is a maximum ratio of loan balance to original loan amount, for example, 110%. If that maximum is reached, the payment is immediately adjusted to the fully amortizing level, overriding any payment adjustment cap. In a worst-case scenario, the required payment increase may be very large.
Identifying Adjustable-Rate Mortgages
There are no industry standards for identifying ARMs, and practices vary across lenders. Some identify their ARMs by the index used, e.g., “COFI ARM” or “6-month LIBOR ARM.” Some identify their ARMs by the rate adjustment periods, e.g., “5/1” or “3/3.”
None of these shorthand descriptions are of much use to borrowers because there are so many differences within each. Indeed, even if the features of each were standardized, to compare one type of ARM with another, one needs to know exactly what those features are.
Selecting an ARM to Qualify
It is easier to qualify with an ARM than with an FRM. In deciding whether an applicant has enough income to meet the monthly payment obligation, lenders usually use the initial interest rate on an ARM to calculate the payment, even though the rate may rise at the end of the initial rate period.
That’s why, when market interest rates increase, ARMs become more common and FRMs less common. Some borrowers who could have qualified with an FRM at the lower rates would now require an ARM to qualify.
However, many borrowers who appear to require an ARM to qualify in fact could qualify with an FRM. It just takes a little more work. After the financial crisis erupted in 2007, it became common to qualify borrowers using the FIR rather than the initial rate. If this practice continues, it will reduce cyclical sensitivity in the market share of ARMs relative to FRMs.
Taking Advantage of Low Initial Rates
Borrowers with short time horizons can take advantage of the relatively low initial interest rates on ARMs. For example, at a time when a borrower is quoted 6.5% on a 30-year FRM, the quoted initial rates on 3/1, 5/1, 7/1, and 10/1 ARMs might be 6%, 6.125%, 6.25%, and 6.375%, respectively.
The correct choice depends on how long the borrower expects to have the loan and on what the borrower’s attitude is toward risk. For example, a borrower who expects to hold the mortgage for 6 years might play it safe by selecting a 7/1. Or he might take the 5/1 on the grounds that the savings over 5 years justifies taking the risk of having to pay a higher rate in year 6.
Borrowers who take this risk, whether deliberately as in the example above or inadvertently because they aren’t sure how long they will hold the loan, should consider what can happen at the end of the initial rate period. Suppose the borrower deciding between the 5/1 and 7/1, for example, finds that the indexes, margins, and maximum rates are the same, but the rate adjustment caps are 2% on the 5/1 and 5% on the 7/1. This could tilt the decision toward the 5/1.
If the ARMs being compared differ in a number of ways, however, comparing one with another (or with an FRM) can be very confusing. In this situation, borrowers with short time horizons seeking to take advantage of low initial rates on ARMs are no different from borrowers with longer horizons who seek to pay less on the ARM over the life of the loan and are prepared to take the risk that they will pay more. Both should analyze the potential benefits and risks. with calculators, as explained below.
Mandatory Disclosures For ARMs
The theory underlying the Federal Reserve’s disclosure rules for ARMs is that consumers should first receive a general education on ARMs and then should receive specific information about any ARM program in which they might be interested. This is a reasonable approach.
The general education is provided by a Consumer Handbook on Adjustable Rate Mortgages, sometimes referred to as the “CHARM Booklet.” The booklet is a passable effort, but it is too long and so few people read it. The second part of ARM disclosure is a list of ARM features that must be disclosed and an explanation of “each variable-rate program in which the consumer expresses an interest.” This is where the process breaks down. The list of ARM features is too long and includes all kinds of pap.
Overwhelming borrowers with more information than they can handle is counterproductive. Disclosing everything is much the same as disclosing nothing—it just takes longer.
Lenders don’t make this mistake. They know they can’t sell an ARM (or anything else) by overwhelming the customer. They tend to focus on a single theme or hook—an easy to-understand ARM feature that is appealing. For example, in 2003 they sold COFI ARMs based on the stability of the COFI, and in 2005–2006 they sold option ARMs based on the low initial payment.
ARM disclosures would be a useful counterweight to lender sales pitches if they were limited to critically important information and presented clearly. Instead, borrowers are presented with a list of ARM features, including those needed to derive useful tables, provided that the borrower knows (a) which items are relevant and (b) how to derive the tables from them. But such borrowers don’t need mandatory disclosure; they can get the information they want by asking for it.
Mandatory disclosure is for borrowers who don’t know what they need and, therefore, don’t know what to look for in voluminous disclosures.
In addition to the list of ARM features, lenders are required to describe each program, but there is no requirement for clarity. So long as the mandated items are included, it seemingly doesn’t matter whether the descriptions are comprehensible. I have seen a few that are pretty good, but most are unreadable.
In the fall of 2009, the Fed released a major set of proposals to revise Truth in Lending, which included substantial changes in ARM disclosures. The CHARM Booklet is replaced by a one-page explanation of the basic differences between ARMs and FRMs, and loan program descriptions would be streamlined and simplified.
Some ARMs have an option to convert to an FRM after some period, at a market rate. The advantage, relative to a refinance, is that the conversion avoids settlement costs. The disadvantage is that the borrower loses the flexibility to shop the market.
The conversion interest rate on the FRM is usually defined in terms of the value of a rate index at the time of conversion plus a margin. To determine whether the conversion option has value, assume you can convert immediately. Find the current index value, add the margin, and compare it with the best FRM rate you can obtain in the market. If the second rate is lower, which is likely to be the case, the conversion option has little value.
Market conditions do change, and it is possible that the option could have value in the years ahead. But don’t give up anything important for it.
Annual Percentage Rate (APR) on an Adjusted Rate Mortgage (ARM)
Annual Percentage Rate (APR) is a measure of the cost of credit that must be reported by lenders under Truth in Lending regulations. The APR was designed to be a comprehensive measure of all costs, which borrowers could use to compare one type of loan with another, as well as to compare offers for the same type of loan from different loan providers.
Under the regulations, whenever lenders disclose an interest rate, they must disclose the APR alongside it. For reasons indicated below, it has never served this purpose adequately and is much inferior to Time Horizon Cost.
On an ARM, the quoted interest rate holds only for a specified period. In calculating an APR, therefore, some assumption must be made about what happens to the rate at the end of the initial rate period.
The rule is that the initial rate is used for as long as it lasts, and the new rate or rates are those that would occur if the interest rate index used by the ARM stays the same for the life of the loan. This is a “no-change” or “stable-rate” scenario.
Under a stable-rate scenario, at the end of the initial rate period, the interest rate used in calculating the APR adjusts to equal the “fully indexed rate,” or FIR, subject to the adjustment cap. The FIR is the value of the interest rate index at the time the ARM was written plus a margin that is specified in the note.
If the start rate on a 3/1 ARM is 4%, the current index 2%, and the margin 2.25%, the APR calculation will use 4% for 3 years and 4.25% for 27 years. But if the current index is 4% and the rate adjustment cap is 2%, the APR calculation will use 4% for 3 years, 6% for 1 year, and 6.25% for 26 years.
When the FIR is above the initial rate, as it was during most of the 1990s, the rate increases on a no-change scenario. The APR is above the initial rate even if there are no lender fees. When the FIR is below the initial rate, as it was during most of the first 10 years of the new century, the rate decreases on a no-change scenario. If not offset by high upfront fees, this will produce an APR below the initial rate.
There is nothing wrong with the procedure used to calculate the APR on Adjustable-Rate Mortgages (ARMs), but borrowers don’t understand it. Further, the APR does not tell borrowers anything about the potential riskiness of an ARM, which is their major concern.