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While ARM contracts in many countries abroad allow rate changes at the lender's discretion (Discretionary ARMs), in the U.S. 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 ARM: Borrowers may select an ARM in preference to a fixed rate mortgage (FRM) for three reasons:
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 one 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. The first condition is that 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 second condition is that the new rate cannot exceed the contractual maximum rate. Maximum rates are usually five or six percentage points above the initial rate. During the second phase of an ARM's life, the interest rate is adjusted periodically. This period may or may not be the same as the initial rate period. For example, an ARM with an initial rate period of five years might adjust annually or monthly after the five-year period ends. The Quoted Interest Rate: 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. See How the Monthly Payment on an ARM Is Determined. The 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. For example, 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. 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. I would avoid it. 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 (not "coffee"). Most of the others are significantly more volatile. These include the Treasury series of constant (one-, two-, or three-year) maturity, one-month and six-month Libor, six-month CDs and the Prime Rate. Another series known as MTA is a 12-month moving average of the one-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 stable index. Current and historical values of major ARM indexes can be found on the following Web sites: mortgage-x.com, bankrate.com, nfsn.com, and hsh.com. How the Monthly Payment on an ARM 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. For example, a $100,000 30-year ARM has an initial rate of 5%, which holds for five 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 five 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:
Virtually all ARMs are designed to fully amortize over their term. This means that negative amortization can only be temporary and 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.
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