ARMs: Hows, Whos and Whys
What You Need to Know About Adjustable Rate Mortgages
If you're shopping for a mortgage, and a 4.5% 30-year fixed rate mortgage (FRM) isn't all that appealing (or maybe it makes your budget too tight), you should investigate adjustable rate mortgages (ARMs) -- especially hybrid ARMs. You'll be in good company: at times, up to 30% or more of all mortgages being made feature some form of adjustable rate feature. "But I don't like ARMs," you say. "They're confusing, and uncertain, and my payments will go up."
That may not be true -- if you understand how ARMs work, and how to use them to your advantage. We've drafted this simple guide to ARMs to help you to decide whether or not any ARM is for you.
Many ARMs aren't priced or structured for sale in the "secondary market," where loans are pooled together and sold to investors. Because many are put together as "portfolio product", that is, to meet the lender's own needs, there can be much greater flexibility in how they are priced and presented to you. You might also find somewhat more liberal qualifying terms.
ARMs are simply short-term fixed rate mortgages. The longer the fixed rate period, the higher the interest rate you'll pay for that period. For example, a one-year ARM generally has a higher interest rate than does a six-month ARM. A true 3-year ARM, where the rate adjusts every three years, has a higher rate than does the one-year variety, and so on.
The starting rate for ARMs is usually priced at a discount from the "index + margin" formula; this "introductory rate" (sometimes called a "teaser rate") is an incentive for you to take the loan. Real "teaser" ARMs, by definition, have a starting interest rate below that of the value of the index which governs the ARM, and are increasingly rare in today's very low rate environment.
ARMs come in many varieties, but they all work the same way. At the end of the fixed period, the interest rate is changed in accordance with the value of a specified economic indicator, called an index. While there are many indexes used to govern ARMs, the most prevalent types are:
Treasury Constant Maturities (also called Treasury Securities, or TCM): the most common Index; used on one-year ARMs and Hybrid ARMs
Treasury Bills: mostly used for three month and six month ARMs
11th District Cost- of-Funds (also called COFI, pronounced 'coffee'): used mainly on one month and six month ARMs
London InterBank Offered Rate (LIBOR, pronounced 'lye-bore'): short-term values, like the 1 month or 6 month LIBOR are used mainly on one month and six month ARMs; most annual ARMs use a 12-month variety
There are also several other varieties of indexes, including those generated using a so-called 'moving average' of a number of weekly or monthly values, and those contrived by (and available from) only specific lenders.
When the ARM rate is adjusted, the lender (or servicer) finds the value of the Index, and adds a markup, known as a Margin. Generally, the total of your index plus margin equals the interest rate you'll be charged for the next fixed period, however long that may be.
To protect you from large rate increases, most ARMs feature some form of limitations on how much your rate can move from fixed period to fixed period. These limitations are called "caps" or "rate caps". You may hear them referred to as "two and six caps"; they may also be called "periodic and lifetime" caps, "per-adjustment and life" caps, and so on. Although many kinds of cap structures are possible, the most common kinds of caps limit your change at any one time to two percentage points, and a total of six percentage points over the life of the loan. In many cases, these caps also restrict how low your rate can go.
For example, if you have a one-year ARM with a 2% per adjustment cap, and you're paying 5%, the worst you might see next year would be 7% (the best, 3%). Your periodic cap limits your increase -- no matter what the index plus margin add up to.
Here's a better example:
You have a one-year ARM at 3% for the first year. The year comes to a close. The lender takes the value of the index -- for example, 3.25% -- and adds a margin of 2.75% to arrive at your new interest rate. So, your calculation is structured like this: 3.25% (index) + 2.75% (margin) = 6% (new rate).
But wait. You have a limit on how much your rate can move at any one time. Your current rate, plus your cap, is the maximum that you can be charged under the terms of your contract:
Current Rate + Adjustment Cap = Maximum New Rate for this change.
Which calculates as 3.00% (current rate) + 2.00% (adjustment cap) = 5.00% (maximum new rate).
Your current interest rate is 3%, and your cap (limit) is two percentage points. 3.00% + 2.00% = 5.00%, and your interest rate cannot move any higher than 5.00%, so that's what your new interest rate will become.
What happens to the difference? Except in very rare circumstances, the rest is simply discarded. This is the risk the lender or investor takes in making you an ARM; while his benefit is in the fact that your rate will change with market conditions, he may or may not get the maximum value from his investment dollar.
Some ARMs, such as Hybrid ARMs, have limited (or no) caps to limit movement at the first adjustment. Your "initial" cap may allow your rate may bounce up by a full five or six percentage points before regular (periodic) caps come into play.
ARMs come in a variety of adjustment periods -- monthly, every three months, every six months, annually, every three years, and every five years (in addition to others).
What you need to know about Monthly ARMs
Usually based on the 11th District Cost of Funds Index (COFI), London InterBank Offered Rate (LIBOR), or a Moving Average of monthly values of One-year Treasuries (called MTA or sometimes 12-MAT) these ARMs typically feature a very short initial fixed interest period, usually three or six months. After the initial fixed period, your interest rate moves up and down along with changes in the index. Your monthly payment fluctuates, too. However, the COFI is perhaps the slowest-moving index, changing by only small fractions of a percent at one time. In 2014, for example, the COFI index moved an average of less than 0.01% each month -- with a move over the entire year of just 0.07%. On the other hand, the one-year Treasury moved by about double that amount in a single month.
Because the COFI barely moves, there generally are no "per-adjustment" caps that govern rate changes each month, but there is a lifetime cap, typically 5%. Instead of a periodic interest rate cap, a COFI ARM may have a "payment cap", a feature where your payment cannot increase more than a set amount from year to year, usually 7.5% -- that is, if your payment in year one is $100 per month, your payment in year two will be no worse than $107.50 per month.
Here's an example: The index has been slowly rising, and your monthly payment, which started the year at $100, is climbing along with it -- and is now at $107.50 each month. Your budget is starting to feel a little squeezed, and here comes this month's bill, with another small increase to $108.25. Your lender will usually now give you an option: send in only $107.50 (minimum payment due) or send in $108.25 (actual amount due). You send in the $107.50, since money's tight. What happens to the other 75 cents?
Unlike rate-capped ARMs, the difference between your actual payment and the larger payment isn't discarded. It's added back onto what you owe, a process called negative amortization. Next month, you'll be charged interest on that additional 75 cents you 'borrowed', since the loan balance you still owe just went up by the 75 cents you didn't pay this month. If the process goes on for a long period of time, you could end up owing more than you initially borrowed!
Why would anyone want such a thing? Well, it's one way to keep your budget intact in a time of rising rates. Also, if you are thinking of selling your home, it can help keep your cost of ownership down, especially if home prices are increasing enough to offset any additional money you might owe when the home is sold. Because the COFI ARM moves so slowly, you're less likely to be affected by the kind of spike in rates than can happen with a TCM-based ARM.
Traditional ARMs have interest rates and monthly payments that adjust at fixed, regular intervals. For years, the most popular and most widely offered kind was the one-year ARM, which has an interest rate that changes once each year. There are varieties of traditional ARMs that adjust in six month, one year, three year and even five year intervals (although true five-year ARMs are a rarity these days).
Most traditional ARMs with rate adjustment periods of one year or longer rely upon Treasuries to govern their changes, but varieties of LIBOR are growing in popularity as well. Typically, for example, a one-year ARM is keyed off the One-Year TCM, three-year ARM off the Three-Year TCM, and so on.
Traditional ARMs with regular adjustments of one year of less may rely on a number of indexes to govern their movements. For monthly, three month and six-month ARMs, investors may use Treasury Bills, which come in one-month, three-month and six month terms. You may also find that these short term ARMs sometimes use the 11th District (or other) Cost of Funds Index (COFI), or may use the London InterBank Offered Rate (LIBOR) as an index. Why would an investor use LIBOR, an offshore rate roughly equivalent to our Federal Funds Rate, as an index for an American ARM? It simply makes the loan, or pool of loans, easier to sell to offshore investors. Aside from these, there are also contrived indexes, like the Moving Treasury Average (MTA), or the so-called Federal Cost of Funds (Fed COF), which averages all outstanding Treasury notes and bonds to arrive at a value.
Index Confusion: The Name Game
To confuse the index matter, many discussions of ARMs focus around the "one-year Treasury Bill". There is such a thing as a "12 Month Treasury Bill," but it's rarely used as an index on any ARM. The Bill is auctioned only once per month, which makes it easy to discern from the commonly-used Treasury Constant Maturity, which has both a weekly and a monthly value. So, if someone tells you the index is the "weekly average of the Treasury Bill" you know that can't be right -- it must be the Treasury Security. The best way to be certain is to read the actual language of the ARM contract; the proper information will be located in the Note or Adjustable Rate Rider which accompanies it.
Among the most popular ARMs today are the so-called Hybrid or 'delayed first-adjustment' ARMs. These ARMs feature a fixed interest rate for a period of years -- commonly 3, 5, 7 or 10 years -- before they turn into a traditional one-year ARM for the remainder of a 30-year term.
The fixed interest rate period is not governed by any index or margin, and lenders have some leeway to price the products to meet their needs. This means that when shopping, you may find a wide range of interest rates being offered to you. For example, a recent weekly survey by HSH pegged the range of initial interest rates available for a conforming 5/1 ARM from the mid twos to the mid 4 percent range across the country. By way of comparison, this is a much larger spread from high-to-low than was found for the same week for a similar 30 year fixed rate mortgage.
The hybrid ARM makes for an interesting alternative to normal fixed rate and traditional adjustable rate mortgages, because it allows the borrower to choose how much fixed rate and how much adjustable rate mortgage he or she wants. Like traditional ARMs, the interest rate you'll pay increases along with the increase in the length of the fixed period. This means that a 3/1 hybrid has a lower rate than a 5/1, which has a lower rate than a 7/1, which in turn has a lower rate than does a 10/1 ARM.
A special note about "caps" for Hybrid ARMs: Most Hybrid ARMs have an additional layer of interest-rate limiter, called the "first adjustment" or "initial" cap, which applies only after the fixed-rate period of the Hybrid comes to an end. Thereafter, typical "periodic" caps will apply.
However, that first adjustment cap may provide little or virtually no protection against a hostile rate environment.
First adjustment caps on Hybrid ARMs can provide some rate-change limits, as in the case of a "2/2/6" cap structure (no more than a 2 percentage point change to your existing interest rate at the first adjustment); considerably less protection, as in a "5/2/6" cap arrangement (your rate can jump as much as five percentage points at the first change) or no real protection at all, where your rate can climb all the way to the maximum allowable interest rate (a "6/2/6" cap). There are also caps structures of "5/2/5", "2/2/5" and other arrangements. Be aware that lenders may offer any or all of the above cap arrangements on their Hybrid ARMs, so it's up to you to ask about them, especially if you believe that sharply higher interest rates down the road might cause you hardship. In some cases, your choice of cap structure will influence the interest rate you can be offered, but you might prefer a slightly higher rate today for more protection tomorrow.
Why ARMs at All?
You may not know that ARMs are a fairly recent addition to the mortgage menu. When they were first introduced over 30 years ago, fixed rate mortgages (FRMs) were at or near then-record highs of 16% to 18%. With FRMs at unaffordable levels, the housing markets threatened to come to a screeching halt. The earliest ARMs were complex, confusing things, especially to borrowers used to the simplicity of fixed rate mortgages. Worse, these proto-ARMs featured no caps, and rates were considerably more volatile than now; in 1981 the one-year Treasury frequently rose and fell by more than one percentage point per week!
In addition, early ARMs were priced with interest rates equal to -- and sometimes above -- comparable FRMs. Given the very real threat of payments jumping even higher, the early ARMs weren't much of a hit.
The second generation of ARMs was much improved -- they featured caps and introductory ("teaser") rates. Borrowers took a second look, and found that they were a good proposition: interest rates were so high that they were likely to fall in the near future, and lenders were happy to make loans and collect interest payments again. At one time, ARMs made up some 75% or more mortgages originated.
In the years that followed, many mortgage products came and went, but ARMs remained. Hybrid ARMs joined the scene in the late 1980s, meeting a need of the jumbo mortgage market. Since the advent of ARMs, their appeal hasn't been universal, but borrowers with certain characteristics have been drawn to them.
Which Borrowers Prefer ARMs?
Originally, borrowers were drawn to ARMs not only because of their lower interest rates, but especially because they couldn't qualify for the FRM they really wanted. Short-term ARMs became popular with folks who liked the opportunity for a lower rate down the road, and among jumbo borrowers who sought to maximize their cash flow for more productive endeavors. Longer-term ARMs found favor among those who feared frequent rate changes and the uncertainty they brought to a budget.
How can you decide whether an ARM is for you or not? The best way is to match up your time frame, whatever it may be, against the fixed period of your loan and the costs of having the loan over that period. For example, short-term ARMs fit short-term time frames. If you're a corporate executive who gets transferred frequently, why pay for a long-term fixed-rate mortgage when the odds favor you'll be moving in just a few years? If you're convinced that interest rates are 'high' today, and if you're willing to gamble that they'll be lower next year or the year after that, you might be drawn to a short-term ARM.
Maybe you're just willing to gamble that rates won't rise much either, so a monthly ARM might be right for you. A low introductory rate, a little bump in rates, and a slow, steady climb might suit you better than the twitchy, more unpredictable nature of a one-year TCM ARM. You may be able to benefit from a rate that's better than an available fixed rate for a good while, and save yourself some money -- while not exposing your budget to too much interest rate risk.
There were (and still are) borrowers who take short-term ARMs of a year or less, and refinance if the rate they receive at the first adjustment isn't to their liking. Essentially, they get a low-cost fixed rate loan with an interest rate as much as 2 percent below a comparable 30-year FRM. If the fees are low enough, they get all their money back and then some each year -- all while paying down their loan a bit faster than if they had selected a FRM. The lower rate means they'll pay down principal slightly at a slightly faster rate, leading to reduced interest charges.
For example, after a year with a $100,000 fixed rate mortgage at 5%, you'll have paid $4,967 in interest, and will still owe $98,525 in principal. After the first year with a one-year ARM at 3%, you'll pay only $3,216 in interest and only owe $97,735 in principal. You would refinance to a new low introductory rate, and start over again. This scheme is probably a bit too much work for average folks, though, and you'll need to beware of prepayment penalties that may negate any benefit.
Tuning Terms with Hybrid ARMs
Intermediate term ARMs -- like the hybrids and 3/3 or 5/5 ARMs before them -- allow you to 'tune' your mortgage to more closely meet your time frame. If you're not planning on living in your home for the next 30 years, it may not make sense to take a 30-year FRM when you may be able to have all the fixed rate mortgage you'll ever want or need at a lower rate. For example, if you're buying a small starter home but planning on having a large family, you're probably not going to be in the mortgage (and maybe not even this home) for very long. If you can reasonably guess that you'll move up within five or six years, you're a candidate for a hybrid ARM. An ARM with its first adjustment seven or 10 years away would be -- for all practical purposes -- a fixed rate mortgage. You'd enjoy savings of one-quarter to one-half percentage point compared to a 30-year FRM.
For almost any borrower, it's possible to find at least one scenario where an ARM of some form can fit into their plans. Even people nearing retirement, but with a number of years yet to run on an existing mortgage, might consider refinancing. By taking a lower-cost ARM, and using the savings to more fully fund a pension plan, an IRA, or just to free up cash prior to retiring, such a borrower can gain enormous flexibility with a simple change of their mortgage product.
Is an ARM Right for You?
If you haven't considered an ARM before, you certainly should. The short checklist below will help you to determine if some form of ARM might be for you. Just check any that apply:
A checkmark on at least some of these questions indicates that you probably won't be holding a 30-year FRM for anywhere near 30 years. You may expand your home, move, refinance, retire and move or want more productive cash flow. All of these argue in favor of some form of ARM.
Once fixed rate mortgages move well above near record-low levels, selecting one won't be the 'no-brainer' it presently is. Instead, you'll have to choose among your options carefully and plan wisely in order to get the best mortgage deal for your circumstance.
Remember: Your mortgage is a kind of 'reverse investment.' Like any investment plan, you should have some idea of how you'll want (or need) your investment to perform over a period of time in order to reach your goals. There are many investment options, each performing differently, each with different risks and rewards. Just as the right investment for your needs can make you money, choosing the right mortgage for your needs can save you money, and lots of it.
Copyright 2014, HSH© Associates. All rights reserved.
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HSH Associates, Financial Publishers
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