A Comprehensive Guide to
Adjustable Rate Mortgages
If you're shopping for a mortgage, and a 6% 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 risky, and my payments will go up."
That may not be true -- if you understand how ARMs work, how to plan for any risks they pose, and how to an ARM to your advantage. We've drafted this 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 than those found on fixed-rate mortgages. More on that later; let's start with how ARMs work.
Adjustable-Rate Mortgage Basics
Conceptually, ARMs are simply short-term fixed-rate mortgages strung together. 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 initial interest rate for an ARM is often priced at a discount from the formula that produces future rate changes (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 most rare when interest rates are low.
The "index + margin" formula is calculated by taking the value of a specific financial indicator (the "index"), adding to it a markup (the "margin") and the sum of the two (subject to rounding and limitations described below) is the loan's fully-indexed interest rate.
Although the loan's interest rate will periodically change, the actual term of the loan is almost always a full 30 years.
ARM Indexes: How ARM Rates Change
ARMs come in many varieties, but they all work the same way. At the end of a fixed-rate 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:
Secured Overnight Financing Rate (SOFR), the index used on ARMs salable to Fannie Mae and Freddie Mac
Treasury Constant Maturities (also called Treasury Securities, or TCM): the most common Index; used on one-year ARMs and Hybrid ARMs
MTA / 12-MAT, aka Moving Treasury Average, used on some monthly and annual ARMs
Federal Cost of Funds, used mainly as a replacement index for other COF-based ARMs, especially monthly ARMs
Some Legacy ARM indexes
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
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
There were 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.
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'll 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.
ARM Interest Rate Caps
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 not more than a total of six percentage points from the loan's starting rate 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% (and 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 longer-term 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.
Common and Uncommon ARMs
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).
The most common ARMs come in terms of:
- 1/1 - rate adjusts every year
- 3/3 - rate adjusts every three years
- 5/5 - rate adjusts every five years
- 3/1 - rate fixed for three years, then adjusts every year
- 5/1 - rate fixed for five years, then adjusts every year
- 7/1 - rate fixed for seven years, then adjusts every year
- 10/1 - rate fixed for ten years, then adjusts every year
- 3/6m - rate fixed for three years, then adjusts every six months
- 5/6m - rate fixed for five years, then adjusts every six months
- 7/6m - rate fixed for seven years, then adjusts every six months
- 10/6m - rate fixed for ten years, then adjusts every six months
All of these have full loan amortization terms of thirty years.
We've also seen uncommon ARMs from time to time, too, those with 15 or 20-year total amortization terms, monthly or three-month adjustment period and others. There's plenty of room for creativity in ARMs, and we've seen a range of innovations over the years -- some good, some bad, and some pretty complicated. An instrument that has cropped up a number of times over the history of ARMs is the monthly ARM. Although rare today, these complicated instruments deserve special attention, since they operate rather differently than more conventional ARMs.
What you need to know about Monthly / Payment Capped 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 interest 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.
Because many monthly ARMs allowed for negative amortization, these products cannot be Qualified Mortgages. That doesn't mean they are banned, but this does make them rare today.
Traditional ARMs: 1/1, 3/3 and 5/5 ARMs
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 were used for a time, too. 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 yields on secondary market Treasury Bills, which come in one-, three-, six- and twelve-month terms.
Since ARMs may last as long as 30 years, there are still some legacy ARMs in the market that may still use the 11th District (or other) Cost of Funds Index (COFI), or may use the London InterBank Offered Rate (LIBOR) as an index. These indicators are being phased out and replaced as ARM indexes, with the COFI being replaced by the Federal Cost of Funds index and LIBOR being swapped out for SOFR.
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.
Hybrid ARMs: 3/1, 5/1, 7/1 and 10/1 ARMs
Among the most popular ARMs today are the so-called Hybrid or 'delayed first-adjustment' ARMs. Traditionally, 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. These initial interest rates are usually based on the lender's own cost of deposits, and if rates on savings accounts, certificates of deposit and the like are low, it's a good bet that the initial rates for these will be low, at least relative to long-term fixed-rate offerings.
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.
"New" Hybrids: Fannie Mae and Freddie Mac "SOFR" ARMs
The newest hybrid ARMs on the block really aren't that new, since their structures have been seen before. What's new is that these are now the "standard" ARMs that Fannie Mae and Freddie Mac will buy, and so they have a greater influence in what private lenders may have to offer you.
With LIBOR retired as a financial indicator and being phased out as an ARM index, a new benchmark ARM index was developed for use. The Secured Overnight Financing Rate from the Federal Reserve Bank of New York is the new index, and Fannie Mae and Freddie Mac will purchase ARMs that use the 30-day SOFR as an index. To this index value, a maximum markup ("margin") of 300 basis points (3%) can be added.
Like previous hybrid ARMs, these have fixed-rate periods of 3, 5, 7 or 10 years; unlike yesterday's offerings, these don't have an annual rate adjustment after that, but rather a six-month rate adjustment period. As such, these are 3/6m, 5/6m, 7/6m and 10/6m ARMs. We saw some of these variants in the private jumbo market back in the mid-2000s, so the concept isn't new, but the index to which these ARMs are tied is.
Six-month ARMs have a little different cap structure than do annually adjustable loans. Rather than a 2% annual limit on the interest rate change, these have a 1% cap every six months, so the effect is roughly the same, although your rate (and payment) will change more regularly. Since these increases are passed along more frequently, this may work to your disadvantage when rates are rising, but may also work to your benefit when rates are falling, as you won't have to wait for up to a full year to see your monthly payment decrease.
As with all hybrid ARMs, these new SOFR-indexes products have an initial cap on the first rate adjustment, a periodic cap on changes at each rate-change interval and a lifetime cap (sometimes expressed as a ceiling or "maximum rate" in ARM documents).
For the GSE's standard offerings, the cap structures are:
- 3yr/6mo ARM: 2% initial cap, 1% per adjustment, 5% over the initial rate lifetime cap
- 5yr/6mo ARM: 2% initial cap, 1% per adjustment, 5% over the initial rate lifetime cap
- 7yr/6mo ARM: 5% initial cap, 1% per adjustment, 5% over the initial rate lifetime cap
- 10yr/6mo ARM: 5% initial cap, 1% per adjustment, 5% over the initial rate lifetime cap
Fannie also regulates other aspects of ARMs they will purchase, including the rate at which borrowers are qualified; that is, even if one of these ARMs if offered to you with a very low initial contract interest rate, the lender will use a different (and likely higher) rate to determine how much mortgage you can borrow.
For loans with an initial fixed-rate period of five years, the lender will qualify you using the greater of either the offered (note) rate plus the first adjustment cap or the sum of the index value plus the margin (aka the "fully indexed" rate).
For loans with an initial fixed-rate period of greater than five years, the lender will qualify you using the greater of either the offered (note) rate or the sum of the lowest index value seen in the 90 days before the application is placed plus the margin (aka the "fully indexed" rate).
That's not to say that these loans can't be offered with a significantly discounted initial interest rate; they can. However, Fannie's guidelines say that the initial rate offered to you can't be more than 300 basis points (3%) lower than a fully-indexed calculation that uses the lowest 30-day SOFR value seen in the 90 days before you apply, plus the margin.
Qualifying for an ARM
Contrary to common belief, an ARM likely won't help you qualify for a significantly larger loan amount. That's because the lender will likely use an interest rate that is higher than the rate they offer to you as a basis for qualifying you for the loan. Essentially, the lender needs to make sure that you'll be likely to handle a higher future monthly payment.
Unlike qualifying conditions seen in the last period of strong ARM originations, lenders today have strict rules on how they qualify you to borrow money. A lender can no longer qualify you at a "teaser" or even an "introductory" interest rate. Rather, ARMs eligible to be sold to Fannie Mae or Freddie Mac now use a variety of calculations to qualify a borrower based on the loan's potential interest rate over a period of time.
Short-term ARMs with initial fixed periods of up to three years must qualify borrowers using the maximum interest rate that could possibly apply during the first five years of the loan. After the fixed period ends, these products adjust every six months, and rate changes are limited by a 2% initial, 1% periodic and 5% lifetime caps. Since rate adjustments in the first five years could potentially see the rate lifted by 2 percentage points for payments 37-42, then another 1 percentage point for 43-48, another 1 percentage point for 49-54 and yet another for payment 55-60, the borrower will essentially be qualified at the highest rate this product might ever reach over the life of the loan, since the changes could amount to a total of a 5 percentage point increase (the lifetime cap).
ARMs with initial fixed periods of five years are treated differently. For qualifying purposes, the lender needs to use the higher of the interest rate produced from two calculations:
The "fully-indexed rate"; or
The initial (aka "introductory", "contract" or "note") interest rate PLUS the initial interest rate cap when the loan is due to adjust for the first time.
Caps for these products are 2% initial, 1% periodic and 5% lifetime, so the calculation would use the "note" rate plus two percentage points.
The "fully-indexed" rate is the sum of the current value of the index to which the loan is tied plus a stated markup ("margin"). ARMs saleable to Fannie Mae or Freddie Mac use a variant of a new index called the Secured Overnight Financing Rate (SOFR) as a basis for making rate changes.
Hybrid ARMs with 7-year or 10-year fixed-rate periods salable to Fannie Mae or Freddie Mac must use the greater of the ARM's note (aka "contract") rate or the fully-indexed rate.
Non-QM ARMs can use other indexes to guide rate changes, such as the value of the One-Year Treasury Constant Maturity, MTA or other instrument. For non-QM ARMs, lenders will usually use the higher of the fully-indexed rate or the note rate, and but also must assume monthly, fully-amortizing, substantially equal monthly payments.
Qualifying calculations
Here's how qualifying for a hypothetical 5/6m ARM would look.
If the value of SOFR is 3%, and the lender is using a margin of 3%, the loan's fully-indexed rate would be 6%, and this would be the rate the lender would use to qualify you.
Lenders may offers introductory rates for ARMs as an inducement for borrowers to take them. However, a lender won't qualify you to borrow based on that introductory rate,
For example, if a lender offers an introductory rate for the first five years of 3.5%, they won't use this rate to qualify you. Instead, the lender must calculate the sum of the introductory rate (3.5%) PLUS the amount of the loan's first-adjustment cap, commonly 2%, although this may be higher or lower.
In this case, the sum of the introductory rate plus the first adjustment cap is 5.5% and is below the fully-indexed rate. Since the lender must use the greater value produced by the initial rate plus cap method (5.5%) or fully-indexed calculation method (6%), the lender must qualify you at the higher (fully-indexed) rate of 6%.
It's important to remember that the loan's interest rate doesn't determine whether or not you can qualify to borrow the loan. Rather, it serves as a limiter on how much mortgage you can borrow based on your income.
Your Qualifying Interest Rate Affects Loan Amount
For example (and all other things being equal) a borrower with an $80,000 income might qualify for a principal and interest payment of $1,867 per month. At a 5% interest rate, this would qualify them for a loan amount of $260,606. However, the same borrower presented with a 6% interest rate would be allowed to borrow only $239,271 -- the higher monthly payment produced by the higher interest rate reduces the mortgage amount, keeping the qualifying payment the same at $1,867 per month.
In the example above, even if you had to qualify to borrow at an interest rate of 6%, your contract interest rate (the quoted introductory rate) would still be 3.5%, and it is this rate on which your payments would be based for the first five years of the loan. So your required principal and interest payment for the loan would be $1,074 for the first five years, leaving plenty of budgetary slack should rates rise in the future.
If a borrower was qualified at the offered rate (3.5%, as was too often the case in the years preceding the housing bust), they would have qualified for a $297,758 loan. When rates increased there would might have been little or no budget space for the borrower to manage higher payments, increasing the chances of delinquency or default.
Why Consider ARMs at All?
You may not know that compared to fixed-rate mortgages, ARMs are a fairly recent addition to the mortgage menu. When they were first introduced over 40 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, and ARMs began to be developed and permitted by regulators.
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, originally 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 (when or if available) 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.
At times, there have been borrowers who took a short-term ARMs of a year or less who refinanced if the rate they receive at the first adjustment wasn't to their liking. Essentially, they got a low-cost fixed rate loan with an interest rate as much as 2 percent below a comparable 30-year FRM for a period of time. If the fees to refinance were low enough, they got 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, as the lower interest rate on the ARM meant they paid 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. It also should be noted that this kind of strategy only works when ARMs are offered at significantly discounted introductory rates.
ARM Strategies: Tuning Loan 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 forecast 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 typically enjoy interest rate 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 to one. Such a borrower could refinance to a lower-cost ARM use the savings to more fully fund a pension plan, an IRA, or just to free up cash prior to retiring. This can provide a homeowner enormous flexibility with just a simple change of their mortgage product.
Planning for / Managing ARM Risks
Although ARMs can bring risks of higher (or even wholly unaffordable) monthly payments at some point, they can at times provide lower monthly payments and even easier qualifying than fixed-rate mortgages, so there can be considerable rewards in ARMs, too.
Of course, ARMs are best taken when market interest rates are fairly high, leaving ample opportunity for lower rates at some point in the future, but these aren't always the market conditions faced by borrowers. Sometimes, interest rates aren't that high, but ARMs can still be appealing, since they may offer payment or mortgage qualification relief.
Ways to prepare for or eliminate risks that an ARM might present
- Eliminate the risk of higher payments by selecting a fixed period that is longer than your anticipated time frame.
For example, let's say that you are buying your first home and expect to be there for perhaps five years. Choosing a hybrid ARM with a 5-year fixed period might work.
However, selecting a hybrid ARM with a 7-year fixed-rate period will cover your 5-year window and provide you with two additional years of fixed payment security. Yes, you may end up buying a bit more "rate insurance" than you end up needing; that said, if your plans have changed five years from now -- or economic or market conditions make it more difficult to sell your home and execute your plan -- you'll have purchased what could be low-cost protection against unfavorable future conditions or changed circumstances.
- Know and understand your risk before you take an ARM.
To help understand your budgetary risk of higher monthly payments, you'll need to do some math using an amortization calculator.
Here's how to do a set of worst-case, best-case and plausible-case scenarios for a common 5/1 ARM.
We'll use a 4% initial interest rate and a $300,000 loan amount.
Although there can be other cap structures, we'll use a 5% initial, 2% periodic and 5% life cap in our evaluation (feel free to use 2/2/5, 6/2/6, 5/2/6 or other combinations you might find in the market).
To do this calculation correctly, first calculate your monthly payment using the loan's initial interest rate. A 4% rate with a $300,000 loan amount with an initial 30-year term will produce a monthly payment of $1432.25. This will be the loan's payment for the first 60 months.
Now, on the calculator, click on "Amortization Schedule" to reveal payment years, and expand the monthly breakout by clicking on the + sign. For the next calculation, you need the remaining balance after the fixed period ends (60 months in this example), so if you started the loan in May 2022, you need to know the remaining balance in April 2027 after the 60th payment has been made. In this case, it is $271,342.54.
Now, add this loan amount back into the calculator's Loan Amount input field. Next, change the loan's interest rate to the starting rate (4%) plus the "worst-case" first-adjustment change of 5 percentage points -- a 9% interest rate. Now, change the Loan Term to 25 years, since this is period that remains from your original 30 year term.
Your new monthly payment of $2,277.10 is the result -- an increase of $844.85 per month. This is the potentially worst-case scenario you'll face.
Before you freak out at the prospect of a 59% increase in your monthly payment, let's consider a few factors.
If this ARM was tied to a 1-year Treasury with a margin of 275 basis points (2.75%), to arrive at an interest rate of 9% -- the worst-case scenario -- the index value used in the calculation would have to be 6.25%. The last time the 1-year TCM was that high? Way back in the year 2000. In fact, the last time we even saw a 5% 1yrTCM was back in 2007, and as we write this, the value of this index is about 2%. As such, the odds of hitting a worst-case scenario at the first rate adjustment are pretty low. Worst-case scenarios are useful and instructive (if scary) but probably don't reflect what reality might be.
For example, rates may not be a full 5% higher after the 60th month, but perhaps they are in an increasing cycle. Do the same exercise as above, but use a 2% first rate change, then do a secondary calculation using the balance remaining after 72 months and a new rate of 2 percentage points more, then again after 84 months and another 1 percentage point. In this way, your first adjustment would have been 2 percent (didn't hit the cap) the second adjustment would have been a full two percentage points (hit the cap) and the third adjustment could only rise 1 more percentage point, as the lifetime 5% rate change would limit it to not more than that (and the rate at the end of the 96th month would then be 9%).
There are many potential outcomes... and don't forget that rates could stay the same or even decline. Run scenarios that include those outcomes, too -- or those where the rate increases at the first adjustment and then decreases in subsequent years, and so on. Pick a scenario, run the calculations, subtract out the margin and look up the index value to see the last time it was at the level you chose, and get a sense for plausibility. It sounds complicated, but once you do it a couple of times you'll be a pro at it.
You should run enough of these to feel comfortable with a range of scenarios and the effects on your household budget.
Another thing or two to consider: There's a good chance that in the future, your income may be higher, so your budgetary pain may be less than it appears today... and also, that opportunities to refinance typically come along every few years.
- Build a "mortgage subsidy" account.
Also known as fiscal discipline, you can plan and prepare your way to ameliorating the future risks an ARM might pose to your budget.
There may be instances where you must "accept" an ARM (in order to qualify, etc) versus times when you can afford a fixed-rate mortgage but instead choose to take an ARM to try to save some money each month.
So let's also look at a scenario -- like today -- where fixed-rate mortgages aren't that high, but high enough to make an ARM look attractive. For argument's sake, let's also say that you can qualify for a fixed-rate mortgage with a rate of 5.25% but the lower monthly payments of a 4% hybrid 5/1 ARM have a strong appeal.
How can you get the lower payments and savings today but protect yourself against future payment pain? Build a mortgage subsidy account. Here's how:
Using a mortgage calculator, calculate the monthly payment for the fixed rate mortgage. A $300,000 30-year FRM at 5.25% carries a $1,656.61 monthly principal and interest payment.
Next, calculate the monthly payment for the ARM with the lower rate. A 4% 5/1 ARM of $300,000 would have a $1,432.25 monthly P&I payment.
That's a difference of $224.36 per month.
If you saved all of this each month, after 60 months you would have built up an account (sans any interest) of $13,461.60, a tidy sum.
After the fifth year, let's say that the 5/1 ARM's rate has increased by two percentage points to 6%; with a remaining balance of $271,342.54 and a remaining term of 25 years, the monthly payment would increase to $1,748.26 (up by $316.01 from what you were paying). Using your "subsidy account" your regular budget commitment of $1,432.25 would remain the same, so there would be no impact on your monthly budget, and over the next 12 months, you would draw down the account balance by $3,792.12, leaving $9,669.48 available to help offset any rate increase in the seventh year of your loan, too.
Even in a worst-case scenario -- a full 5% rate increase as described earlier -- your $13,461.60 would provide an offset to the $844.85 increase in monthly payment for all of the next year (erasing $10,138.20 from your subsidy account) but you would still have $3,323.40 available to help manage higher costs in year seven, too.
Of course, the reason for taking the ARM might have been to make funds available for other things. Even then, saving half of the difference between the fixed-rate and 5/1 monthly payments can buy you months (and perhaps many months) of little to no impact on your monthly budget despite higher interest rates.
- Watch for (and take advantage of) "horizontal" refinancing opportunities.
We mention above that opportunities to refinance typically come along every few years, so that you may be presented with chances to swap out of your ARM to a fixed-rate mortgage you might have preferred. Of course, there's no guarantee that future mortgage rates will be lower than the ARM you currently have. A lower rate (and payment) is often a strong draw for homeowners to refinance.
That said, homeowners who might have preferred a fixed-rate mortgage but selected (or accepted) an ARM should view refinancing with a different perspective. Yes, a lower rate than today would be wonderful, but getting the chance to switch to a fixed-rate mortgage at the same rate you have today is a significant opportunity that shouldn't be passed up.
If you like, call it a "horizontal refinance".
Here'a an example scenario. Using the example above, you have a $300,000 5/1 ARM with a rate of 4% and a of $1432.20 monthly payment
Three years have passed, and over that time, market interest rates for fixed rate mortgages have declined, but only to 4%, not enough to bring you a lower interest rate. As such, there might not be a compelling reason to refinance, except that you have only two more years of fixed rate on your loan, and the short-term interest rates that govern you ARM could certainly be on an upward path at that point.
Refinancing to a new 30-year FRM at 4% (or even at a rate a little above what you have today) can still make sense, since your goal isn't necessarily to lower your payment but instead ameliorate the risk of less- or un-affordable monthly mortgage payments in the coming years.
By way of example, after paying a 4%, $300,000 mortgage for three years, your remaining loan balance will be $283,496.18 so you've made a little dent in what you owed.
A refinance to a new 30-year fixed rate mortgage at 4% would actually drop your payment a little bit, from $1,432.25 to $1,353.45 per month. This is due to the effects of both the lower starting loan balance and re-starting the amortization clock all over again. If you paid $2,000 in fees to get the new mortgage, you would recover your outlay in about 38 months, and more importantly, eliminated your risk of a higher monthly payment when the ARM's rate would have come due to adjust.
In fact, and leaving out paying fees out of pocket to refinance, you could keep your existing monthly payment almost exactly the same as it was even if you refinanced to a new 30-year FRM with a rate of 4.5 percent. You don't necessarily need to wait to get a lower rate or even the same rate you have at the moment to refinance and eliminate the risk of future higher payments.
HSH's "Should I refinance my mortgage?" calculator can help you with the math for this strategy.
Who Offers ARMs?
While almost all lenders will offer at least some kinds of ARMs, adjustable-rate mortgages are most commonly found at depository institutions such as banks and credit unions.
Banks like to hold ARMs in their portfolios of investments, and most banks -- even big banks -- rarely make enough ARMs to make it cost effective to sell them to Fannie or Freddie. As noted above, Fannie and Freddie will only buy ARMs that conform to their specifications, and this can limit the lender's ability to adapt the loan terms and underwriting to better meet their investment needs.
Depending on market conditions, mortgage bankers may or may not offer these products; since they don't hold mortgages in a portfolio of investments, they need to sell any ARMs they make to the secondary market. Because ARM volumes are usually low, when they do originate them, mortgage bankers may originate them for sale to another firm (sometimes a bank) in what's called a "correspondent lending" arrangement.
The FHA program also insures ARMs, mostly structured as the traditional kind of ARMs -- that is, they will back 1/1, 3/1, 5/1, 7/1 and 10/1 ARMs using the 1-Year Treasury as their index. Cap structures on FHA ARMs are a little different, too; 1/1 and 3/1 ARMs are limited to 1 percent per adjustment and a lifetime peak rate not more than 5 percentage points above the loan's initial rate. FHA 5/1 ARMs allow to caps of either 1% periodic and 5% lifetime or 2% periodic and 6% lifetime, and 7/1 and 10/1 FHA-backed ARMs have 2% and 6% caps, respectively. If you're interested in a FHA-backed ARM, you'll want to read "All about FHA ARMs", a deeper look into these.
FHA ARMs allow great flexibility in pricing. HUD notes that "The initial interest rate, discount points, and the margin are negotiated by the buyer and lender."
Shopping for ARMs
Shopping for an ARMs is very different thing than shopping for a fixed-rate mortgage, because there's not just today's interest rate and costs to consider, but tomorrow's, too. Fixed-rate mortgages are standard; that is, they all work the same way no matter who makes one for you. For ARMs, there is wide variability in what loans may be available, from whom, how these products are constructed and the interest rates at which they may be offered to you.
Since most ARMs don't get sold to investors, there can be a lot of variation in what you'll find in your market. This means that the onus is on you to shop as broadly as you can among lenders large and small, and to take good notes from your research or discussions with lenders.
Yes, a low interest rate today matters, since in conjunction with the loan's caps can limit how high your rate might go in the future. At the same time, at least as important as today's rate is what happens later. While neither you nor the lender has any control over what happens to the ARM's index value, what index they use to govern rate changes should matter to you. You need to know what index the ARM is tied to, so you'll want to specifically ask about it.
For example, a monthly value of a one-year Treasury will behave differently than will a weekly value, and a moving average of a monthly one-year Treasury will behave differently still... but these may all be casually described as a "Treasury-based" ARM. It's up to you to ask "What Treasury?" 'Weekly or Monthly (or other) Value?"
While the lender doesn't control the movements of the index and what happens to its value, the lender does have control over the margin they add on top of that value, and the sum of index + margin will eventually become your loan's interest rate. After you inquire about the index being used, you also should ask about the margin that is added on top. All things being equal, a lower margin will produce a lower interest rate on your loan when it begins to adjust.
Limits on rate changes matter very much, too, so you must ask about rate caps. For traditional ARMs, that's the periodic and lifetime cap; for hybrid ARMs, that would include the initial, periodic and lifetime caps. All things considered, lower caps are better -- a 2/2/5 or 5/2/5 cap structure for a hybrid ARM would be better than a 6/2/6, for example. Lower caps can help keep your payments more manageable in a rising rate environment.
You'll want to ask about rate "floors", too. When rates plunged to near zero, some folks with ARMs were likely unhappy to find that some lenders add a "minimum rate" clause to their contracts. Even if they don't, the loan's interest rate will never be less than the declared margin, so if rates plummet to zero again a lower margin will benefit you.
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.
Last Words
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.
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