How to choose among types of ARMs?

An ARM is a loan which allows for the adjustment of its interest rate according to the terms of the note and as market interest rates change. The ARM interest rate is based upon one of many indices which reflect market interest rates. The borrower assumes the risk that interest rates (and their monthly payment) will rise. By assuming this risk, lenders may charge a lower initial interest rate compared to fixed rate loans. The lower initial rate is the main reason borrowers choose ARM loans--it allows them to qualify for a larger loan and obtain a higher-priced home.

Borrowers considering an ARM should familiarize themselves with standard ARM features. These features include:

  • Start rate (Teaser rate): This temporary rate is the starting interest rate. It is often referred to as the teaser rate. The start rate is lower than the fully-indexed rate (sum of the index plus the margin), and lower than the market rate on fixed loans.
  • Initial Adjustment Period: The length of time the interest rate is fixed initially. For example, if the initial adjustment period were six months, the interest rate would remain fixed for the first six months. Beginning in month seven, the loan would adjust at regular intervals.
  • Regular Adjustment Period: The frequency at which the interest rate adjusts. If the regular adjustment period were six months, the interest rate would adjust every six months.
  • First Adjustment Cap: The maximum amount the interest rate can increase when it adjusts for the first time. For example, if your teaser rate and first adjustment cap were 5 percent and 3 percent respectively, the maximum your rate could increase after the initial adjustment period would be 8 percent.
  • Regular Adjustment Cap: The maximum the interest rate can adjust up or down each adjustment period.
  • Lifetime Cap: The maximum interest rate allowed over the life of the loan.
  • Index: The variable index referenced in your note. The margin is added to the index to set the ARM interest rate. The index can usually be found in business newspapers. More information about various indices is available below.
  • Margin: A fixed number which is added to the index to arrive at the ARM rate.
  • Fully-indexed rate: The fully-indexed rate is equal to the index plus the margin. Your loan always adjusts toward this rate.
  • Conversion Options: Some ARMs have an option which allows the borrower to convert the ARM to a fixed-rate loan. Exercising the option usually must ocurr within a predetermined time frame; the fixed rate is determined by a formula. For example, a one-year T-bill ARM may be converted to a fixed-rate loan during the first five years on the adjustment date. I.e., you could convert during the thirteenth, twenty-fifth, thirty-seventh, forty-ninth or sixty-first month.

Computing the fully-indexed mortgage rate:

The formula to calculate the fully-indexed interest rate is: fully-indexed rate = value of index + margin

Note: The rate you pay after one or more adjustments may not be the fully-indexed rate. This can occur when the interest rate adjustments are limited by a cap.

Examples:

  1. Not reaching the fully-indexed rate: Say your previous rate was 7 percent, your loan has a 1 percent adjustment cap, the index is 7 percent, and your margin is 3 percent. The fully-indexed rate is 10 percent. Because of the limiting payment cap, your new interest rate is 8 percent.
  2. Reaching the fully-indexed rate: Now say your previous rate was 7 percent, your loan has a 3 percent adjustment cap, the index is 7 percent, and your margin is 3 percent. After the adjustment, your interest rate reaches the fully-indexed rate of 10 percent.

Details about the various indices:

  1. Prime rate: The interest rate banks charge their best (prime) customers.
  2. Treasury bill rate: Treasury bills are short-term debt instruments used by the U.S. Government to finance their debt. Commonly called T-bills, they mature in less than one year.
  3. Libor: London Interbank Offered Rate. The interest rate international banks in London charge when lending to each other. Indices are quoted for maturities of one, three, six and twelve months. The most common Libor rate referred to in ARMs is the six-month Libor rate.
  4. 6 month CD rate: The average rate that banks pay on a six-month Certificate of Deposit.
  5. 11th District Cost of Funds Index (COFI): The index is the average monthly cost of the interest expenses incurred by members of the 11th District of the Federal Home Loan Bank System. Deposits in checking and savings accounts, certificates of deposit, transactions accounts, and passbook accounts are the primary source of funds for these savings institutions. The COFI moves slowly and lags behind the market. For COFI ARM borrowers, this is an advantage when interest rates are rising, but a disadvantage when rates are falling. When rates are rising, the COFI rate, and consequently the ARM rate, will rise slowly. Conversely, when rates are falling, the COFI rate and ARM rate will decrease slowly.

Popular ARM programs. Some of the more popular ARM programs include:

  • One-Year Treasury Bill ARM - Adjusts annually with a two percent annual cap.
  • Six-Month Certificate of Deposit (CD) ARM - Adjusts every six months with with an adjustment cap of 1 percent. The CD rate is very volatile and changes quickly with the market.
  • Six-Month Treasury Average ARM - This index is relatively stable because it averages the treasury rate over the previous six months. This loan has a maximum interest rate adjustment of 1 percent every six months.
  • Twelve-Month Treasury Average ARM - This index is relatively stable because it averages the treasury rate over the previous twelve months. This loan has a maximum interest rate adjustment of 2 percent every twelve months.
  • Three-month COFI ARM - The COFI is one of the most stable indices and adjusts very slowly. The three-month COFI ARM typically has a very low start-rate for the first three months, after which time the interest is fully indexed and adjusts monthly.

Intermediate ARMS

Lenders also offer ARMs which feature an initial adjustment period with an intermediate time frame. The most popular intermediate ARM loans are the 3/1, 5/1, 7/1 and 10/1. These loans are normally amortized over thirty years with the interest rate initially fixed for three, five, seven and ten years respectively. After the initial fixed period, these loans typically adjust annually.

Intermediate ARMs are very popular with borrowers who want the stability of a fixed rate and the benefit of a lower introductory rate. If you plan to sell or refinance your home in three to ten years, you may want to consider an intermediate ARM loan rather than a fixed-rate mortgage. You can save money with the lower introductory rate, but you risk having a higher rate if you are still in your home when the introductory rate period expires and the rate starts adjusting toward market levels.