Adjustable Rate Mortgages (ARMs)

It’s true that the adjustable-rate mortgages of the early 1980’s gave ARMs a very bad name. Inflation and interest rates were running rampant during that time, and many homeowners had to sell or go into foreclosure because they couldn’t keep up with the skyrocketing payments. This was not exactly good news for the lenders, either.

The adjustable-rate mortgages of today have improved dramatically, with maximum limits on adjustments (caps) in place, as well as mandatory rate disclosure regulations to protect and educate borrowers. However, just as with any other loan program, there is the good and the not-so-good. ARMs best serve home buyers with particular needs and/or problems. As is usually the case, the key to finding the right loan is being knowledgeable about your own financial situation as well as about what’s available, and using that information to make the best possible decision for you. With that said, ARMs definitely have a place in the financial market.

An adjustable-rate mortgage does just what the name implies: its’ rate adjusts. In contrast to a conventional 30-year fixed-rate loan whose interest rate will be the same in month 360 as it is in month number 1, the ARM will fluctuate up or down according to increases or decreases in the particular index that is used for the loan. This index is generally a gauge of inflation for the economy. Lenders can use a wide variety of indexes, or indices; some of the most common ones are: Treasury Securities (one-, three-, five- or 10-year Indexes), the six-month Treasury Bills (T-bills) Index, the National Average Contract Mortgage (NACR) Interest Rate Index, and the Eleventh District Cost of Funds Index.

The rate of an ARM is made up of two parts: the index and the margin. As previously stated, the index is an inflationary indicator. The margin is the lender’s cost of doing business (including profit), and it is added to the index to get the interest rate, or Note Rate.

To better understand how an ARM works, you must become familiar with its components:

• Index
• Margin
• Note Rate
• Initial interest – the rate during the initial period of the loan, which could be lower than the Note Rate as an enticement to prospective borrowers.
• Adjustment period – The interval at which the interest rate is scheduled to change (monthly, semi-annually, annually, etc.).
• Interest rate caps – Limits placed on the up or down movements of the interest rate.
• Convertibility – An option to change from an adjustable- to a fixed-rate loan. A Conversion fee is usually charged for this.
• Negative amortization – This occurs when a payment is insufficient to cover the interest charge. The shortfall amount is added onto the principal of the loan.
• Carryover – Interest rate increases that are in excess of the amount that a cap would allow. This excess may be applied at the next rate adjustment.

Should you consider an adjustable-rate mortgage? The answer, of course, depends upon your own financial situation and goals. Do you expect with some certainty that your income will increase over the next few years? Do you need a lower initial interest rate to qualify? Do you plan to sell the property within a few years? If you answered yes to any of these questions, an ARM loan may be your best choice. But you must be informed in order to make the proper decision. Fortunately, lenders are required to provide you with written information to help you compare and select mortgage loans. Use the information. Ask questions. Use the Federal Reserve Handbook on Adjustable-Rate Mortgages. As always, educate yourself, and you’ll be able to make the best possible decision for you.