Variable rate mortgages, aka adjustable rate mortgages, are mortgage loans where the interest rate can change (adjust) at specified times as allowed for in their program. (The borrower is given a schedule of future adjustments at the closing of the loan. In an ARM promissory note, the changes are spelled out in a schedule called a rider to the note).These rate changes are tied to an index and are calculated based on the index's year's average rate plus a margin. Most of these loans have change caps or ceilings to prevent payments from increasing wildly per change period, as well as life-of-the-loan caps or ceilings. Each rate change (usually one per year) will affect the borrower's payment. Since the subprime era, the types of ARM loans that are available are the safe and conservative ones. ARM loans have grown in popularity over the years, and they are a staple on all lenders' (including government) rate sheets.
Mechanics of ARM Loans
An ARM loan will have three components: an index, a margin and caps. At your change period, the average of the index for that year will be added to your margin. This is the loan's profit margin. You will have safety caps in place on most ARM loans, commonly 2 and 6 percent (2 percent for a change adjustment and 6 percent for a life-of-the-loan cap. If your beginning interest rate is 4 percent, you know that the very worst you would ever see would be 10 percent). Using these components of the ARM loan, let's suppose your current rate is 5 percent, (remember your adjustment cap is 2 percent), your new index has moved to 4.5 percent and now the margin of 2 percent is added to the 4.5 percent, so the new rate can move to 6.5 percent. This is less than the 2 percent yearly cap, so the new rate changes to 6.5 percent, and your payment adjusts accordingly. If the index average had been 5.5 percent and the 2 percent margin were added, your rate could possibly increase to 7.5 percent; however your new rate could only move upward to 7 percent because of the 2 percent yearly cap.
This index average is figured 45 days before the change date, which is your closing date anniversary.
Your index can always be tracked in The Wall Street Journal.
What Are the Changes Tied to?
ARM loans are tied to an index, and while there are many indexes, the ones most commonly used in ARM loans now are the one-year Treasury Bill (known as the one-Year T-Bill) Index, the 12-Month MTA (Moving Treasury Average) Index and the Libor (London Interbank Offered Rate) Index. The calculation used for your index will use the year's average of movements (you don't get the high fluctuations and you don't get the lows). This average is then rounded up to the nearest one eighth of 1 percent. These indexes are all published in The Wall Street Journal.
History
After World War II, families were growing, buying homes and flourishing. Savings and loan associations played a big part in lending mortgage monies. They paid their depositors interest on deposits at a lesser rate than was charged for mortgages; they did not sell the loans, so homeowners always paid their payments to the S&L. S&Ls were profitable, the homeowners were happy, and the investments were safe. The problem with this was that deposit accounts were short-term investments, and mortgage accounts are long-term. Problems arose after inflation on housing caused prices to increase. S&Ls had to pay more money to attract depositors than their long-term investments (mortgages) were bringing in, so mortgage interest rates grew. By 1980, interest rates hit a sky-high 20 percent.
In an effort to help ease home buying and to ensure profits to banks, large California banking institutions introduced adjustable rate mortgages. These early ARM loans were very biased toward the banks, and some had no rate adjustment caps or ceilings and no life-of-the-loan caps. Negative amortizations (where the required payment was not large enough to cover the monthly interest that was due, causing mortgage balances to grow, instead of shrink) abounded. Because of this, many borrowers had a growing mortgage balance that was larger than the home's value. If the homeowner got into financial trouble, and couldn't make his payments, he could not afford to refinance or to sell it because he owed more than it was worth. Many foreclosures resulted from this.
Over time, these ARM loans have improved and features have been added that make them safer choices in lending. The bias is now more toward the home buyer. He has choices in ARM loans that better serve his needs than a fixed-rate mortgage might.
Types of ARM Loans
ARM loans offer the borrower variety and safety .Most ARM loans now offer a "freeze period," and the interest rate is actually fixed for a temporary period of time. There are 3/1 ARMs (fixed for three years and then rolling to a one-year ARM with changes once per year), all based on index plus margin, and caps for the yearly adjustments and a life-of-the-loan cap. There are a 5/1, a 7/1 and a 10/1 ARM, which work the same, fixed for five years, then changing, etc. Young home buyers who are in their first home may predict being in the home for five years before moving up to a bigger home when the family grows. A 5/1 ARM offers freedom of a lesser payment (ARM loans typically start out at a lower rate than the fixed rate would be), and the couple will have sold the home and moved on before their loan was ever adjusted at all.
There are interest-only features with ARM loans as well. The borrower can choose the features that best suite his plans.
Drawbacks and Benefits
There were many drawbacks on the ARM loans in the 1970s. Today, the drawback of the ARM loan is always the upward adjustment in payment, but there are period caps and life-of-the-loan caps in place. In times that the index has increased, so have the payments. (There have been times where the index dropped, and payments adjusted downward). Private mortgage insurance costs more on an ARM.
There are few drawbacks for people who know that they will not be in the home more than the fixed period of the ARM loans (3/1, 5/1, 7/1 and 10/1) today. It may not be the loan of choice when fixed rates are low, but when rates begin to rise, ARMs become popular all over again.
The benefits are that the beginning rate is usually lower than fixed rates and fixed for a choice of periods (three, five, seven or 10 years). Another benefit is the ease in qualifying for the loan. There are no prepayment penalties, so a homeowner is able to refinance the loan to a fixed rate if his ARM choice isn't working for him or if he has decided to stay in the home longer than the time of the fixed rate.
Tags: caps ceilings, fixed rate, interest rate, life-of-the-loan caps, loans have