written by: Tim Plaehn•edited by: Jason C. Chavis•updated: 10/31/2010
The rates for an adjustable rate mortgage can look very attractive in the current, low interest rate environment. However, it is very important to understand the type of adjustable rate mortgages (ARM) before you use any adjustable rate loan to finance or refinance a home.
slide 1 of 5
Types of Mortgages
Mortgages can be broadly categorized into two types: fixed rate mortgages and adjustable rate mortgages -- ARMs. Fixed rate mortages are relatively simple to understand and all work the same. However, there are several different types of adjustable rate mortgages and how the rates on these loans are calculated.
Adjustable rate mortages will have the interest rate on the loan reset on a regular schedule, typically once a year. The interest rates of ARMs are based on short term market interest rates, which are typically lower that the long term rates that are the basis for fixed rate mortgages. A homeowner with an ARM will see his rate and payment go up or down each year when the rate resets to reflect the current interest rates.
There is broad latitude on how a mortgage lender can set up an adjustable rate mortgage. The different types of adjustable rate mortgages are more defined by a particular loan's contract terms rather than have a specific "type". The major mortgage funding sources: Fannie Mae, Freddie Mac, FHA, VA and jumbo mortgage lenders offer ARM loans set up according to the criteria discussed here.
slide 2 of 5
Features of ARMs
The common type of ARM in the U.S. is the one-year adjustable rate mortgage. The rate and payment will reset once a year, typically on the anniversary date of the loan. Hybrid ARMs have the initial interest rate fixed for a period of three or five years and then start resetting on an annual basis. Hybrid ARMs will be often listed as a 3/1 or 5/1 ARM. After the initial fixed rate period, these loans work just like a one-year ARM.
The interest rate on an ARM is based on an index rate and a margin. The index rate will be a widely followed short-term interest rate such as the one-year Treasury bill rate. The margin will be specified in the mortgage contract and will usually be between 1.5 and 4 percent, with most ARMs written with margins of 2 to 3 percent. The initial rate for one, three or five years will often not be based on the index and margin. The initial rate can be a "teaser" rate to make the initial rate and payment more attractive.
An adjustable rate mortgage contract will also have rate caps. These caps limit how much the rate can adjust upward during any annual reset and over the life of the loan. For example, a contract may limit the rate increase to one percent in any one year and six percent over the life of the loan. The contract may also have a makeup clause that allow the rate to continue to increase in subsequent years if the annual cap has prevented the rate from reaching the fully indexed rate.
slide 3 of 5
Additional resources and details for analyzing an adjustable rate mortgage and determine if it is a good option for your home financing needs.
slide 4 of 5
Analyzing an ARM
Before signing on the dotted lines for an adjustable rate mortgage a home buyer should understand how that particular ARM will function. Find out what are the index rate for the loan and the margin amount. Calculate the current, fully indexed rate for the mortgage. This is the current rate for the index plus the contract margin amount. If the initial rate for the loan is below the fully indexed rate, the first year rate is a teaser rate any the mortgage could increase next year even if rates stay level or decrease. Note: for 3/1 and 5/1 ARMs the initial rate is some sort of market driven rate that has not effect on the mortgage rate after the initial rate period is up.
The common rate indexes for ARMs are the one-year constant maturity Treasury -- CMT, the 11th District cost of funds index -- COFI -- and the 6 month or one-year London Interbank rates -- LIBOR. Figure out where to look up the current value for these rates before you sign that new ARM contract. For comparison, in October 2010 these rates were at the following levels:
CMT: 0.22 percent
COFI: 1.713 percent
LIBOR, 1-year: 0.77 percent
When the rate on a ARM resets, the mortgage company determines the new rate and calculates a payment based on the rate and an amortization using the years remaining on the loan. It is important to calculate, or have the loan officer calculate the maximum possible payment for the first several years after the loan is originated. This worst-case analysis can prevent a big surprise a few years in the future if interest rates start to increase.
When comparing different ARM loans, the possible future reset rates and payments are more important than the current rate being quoted. A good ARM has a low margin based on a rate index that will reflect the lowest possible short term rates. In the U.S. in 2010, short term rates are near zero and a good ARM should be resetting at will below 3 percent. Short term rates are driven by government policy. Comparison shopping may result in significant mortgage savings for a homeowner who understands how an ARM works.
slide 5 of 5
For more information on adjustable rate mortgages check out these articles:
Is an Adjustable Rate Mortgage a Good Idea?
Should I Get an Adjustabl Rate Mortgage?
Federal Reserve Board: Consumer Handbook on Adjustable Rate Mortgages, http://www.federalreserve.gov/pubs/arms/arms_english.htm
Bankrate: Tracking Leading Interest Rates, http://www.bankrate.com/rates/interest-rates/rate-watch.aspx