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FAQ: Adjustable Rate Mortgages
Understanding the complexities of adjustable rate mortgages is no easy task. Unlike a fixed rate mortgage on which interest is paid at the same rate throughout the life of the mortgage, the rate of interest charged on an adjustable rate mortgages (commonly called an “ARM”) will change at least once, and usually many times over the life of the loan. The most common ARMs will provide for interest rate changes either monthly, every 6 months or once every year. The rate changes periodically on a date known as the “change date”.
On each change date, the interest rate which will be charged until the next change date under the terms of the mortgage note is determined by adding a number called the “margin” to an “index” which is commonly published in periodicals such as the Wall Street Journal. A common “index” which is frequently used to determine the interest rate charged by banks on loans is the “prime rate”. On permanent mortgage loans, the most commonly utilized indexes are the yield on the “one year Treasury Bill”, the “6 month or 1 year LIBOR” (London Interbank Offered Rate), and the “11th District Cost of Funds (commonly called the “COFI”). Let’s assume that on January 27th these indices had the following values:
On the change date of the ARM the margin will be added to the index to determine the new interest rate. Margins on ARMs typically range from 2.250% to 3.000%. Thus, if the change date was on January 27th, the margin on an ARM was 2.250% and the index for the ARM was the One Year LIBOR, the new rate would be 4.92% (2.670% + 2.250%). The rate which results from sum of the index and the margin is referred to as the “fully indexed rate”.
As if the procedure of determining the indexed rate were not complicated enough, there are other factors which can result in a different rate than that derived from the above-described formula. It is not uncommon for ARMs to have a start rate or beginning interest rate that is considerably less than the fully indexed rate. For example, the note which had a fully indexed rate of 4.92% might have a start rate of 2.750%, below the fully indexed rate. Or if it is a “hybrid” fixed-ARM, the rate for the initial 3, 5 or 7 year fixed period might be higher than the “fully indexed rate”.
The amount by which the interest rate charged on an ARM can change from one change date to the next (or over the entire life of the loan) is typically limited by what are called “caps”. There are “per change caps”, “initial caps” and “lifetime caps”. The “per change cap” limits the amount by which the interest rate can be increased or decreased from one change date to the next. However, on the initial change the cap might be different. Typically the “initial cap” will be equal to the “lifetime cap”. The lifetime cap, when added to the start rate, determines the highest possible rate to which the ARM can adjust regardless of what the “fully indexed rate” might be. Let’s assume the following for illustration. A start rate of 2.75%. A “per change cap” of 2 points. An “initial cap” of 5 point and a “lifetime” cap of 5 points. This is often stated as a loan with 5/2/5 caps.
The “initial cap” will usually permit the initial adjustment to be higher than the “per change cap” limit. Thus, in our example, if an ARM had a “per change cap” of 2 and adjusted annually, the new interest rate on the first change date utilizing the “per change cap” would have been 4.750% if there were no “initial cap”, even though the fully indexed rate might be higher at the time of the change. This is because the rate can never increase by more than 2 percentage points on any one change date (unless there is an “initial cap” rate). In our example, although the new rate on the change date would 4.75% if determined by the “per change cap”, because the “initial cap” is 5, the rate will adjust to the lower of either the “initial cap” rate of 7.750% (2.750% start rate plus an “initial” cap of 5 points) or the “fully indexed rate” of 4.92% (the LIBOR “index” of 2.67% plus the margin of 2.250%). In this example, because the “fully indexed rate” on the change date is lower than both the “initial cap” and the “lifetime cap” the rate will adjust to the “fully indexed rate” because it is the lower than the capped rates.
On some adjustable rate mortgages you can elect a “conversion option” which will allow you to convert the ARM to a fixed-rate mortgage (at the prevailing 30 year interest rate at the time of the conversion) for a nominal conversion fee. The option must typically be exercised between the 13th and 60th month of the mortgage.