It is popular with the lenders because the ARM shifts the risk of interest rate fluctuations to the borrower.

Although borrowers would rather have the security of a fixed-rate loan provided the rate is not too high, the ARM has maintained its popularity in the market despite competitively priced mortgage loan rates.

An ARM is a loan that allows the lender to adjust the interest rate so it reflects fluctuations in the cost of money more accurately.  However, with an ARM, the borrower is the one who is affected by interest rate movements, not the lender.  If interest rates rise, the borrowers payments also go up - if the rates fall, the borrowers monthly payments will drop along with the declining rates.
 

HOW AN ARM WORKS

The borrower's interest rate is determined by the cost of money at the time the loan is made.  Then the rate is tied to a recognized index your lender is currently using for this loan.  Your future interest adjustments are then based on the upward or downward movements of this index.  An index is a reliable statistical report that reflects the approximate change in the cost of money.   Some examples of this would be the monthly average yield on three year treasury securities, or the national average mortgage contract rate for purchases on previously occupied homes.  The rise and fall of your payments will fluctuate with the index preferred by the lender for this loan program when your loan was made.

To insure that the expenses of administration and profit are included in the payments to the lender, it is necessary for the lender to add a margin to the index.  Different lenders use different margins which explains the variation in  interest rates offered for the same loan program.  Margins range from 2% to 4% and are added to the index to come up with the interest rate you pay (margin + index = interest rate).  It's the fluctuation of the index rate that causes the borrowers interest rate to increase or decrease.

ELEMENTS OF AN ARM

1. Index
2. margin
3. "Teaser rates"
4. Rate adjustment period
5. Interest rate cap
6. Mortgage payment adjustment period
7. Mortgage payment cap (if any)
8. Negative amortization cap (if any)
9. Conversion option (if any)

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Lenders generally use an index that will be responsive to fluctuations in our economy - usually a one-year Treasury security or the cost-of-funds index (COFI).  The cost-of-funds index is more stable than the Treasury index because it doesn't rise or fall as sharply over the long term as the Treasury index.

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MARGIN:

The margin is the difference between the index rate and the interest charged to the borrower.  The margin doesn't change throughout the loan term.

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"TEASER RATES"

A "teaser rate" is a reduced, first-year introductory interest rate designed to attract borrowers to ARM's.  In the past, lenders were losing money on fixed-rate mortgages because these loans were yielding less than the prevailing cost of money.  Offering the adjustable-rate mortgage allowed lenders to insulate themselves from these losses and increase earnings by passing the risk of interest rate fluctuations on to the borrower.  To make the ARM attractive to borrowers, a low beginning interest rate was offered and through time these introductory rates became known as "teaser rates".  The interest rate would then rise at each rate adjustment period until the rate equaled the index rate + the margin.  For example, let's say that the introductory rate ("teaser rate") for your adjustable-rate loan started at 4.5% interest and would adjust upward 1.0% every six months.  If your index for this loan was 5.0% and the lenders margin was 3.0%, then the interest on your loan for the first six months would be 4.5%.  Six months later, it would increase to 5.5% and so on until the fully-indexed rate was reached.  To find the fully-indexed rate, you would add the index to the margin (5.0% + 3.0%).  After the fully-indexed rate was reached, your loan would then fluctuate with the index on your loan.  If the index goes up or down, your payment would increase or decrease with the rise or fall of the index on your adjustment period change date.

RATE ADJUSTMENT PERIOD:

The borrowers interest rates on an adjustable-rate mortgage are allowed to be adjusted at certain intervals during the loan term.  Depending on the type of adjustable loan you have, this interval could be six months, one year, three years or more.

INTEREST RATE CAP:

There are limits on just how much your payments can go up if you have an ARM.  Usually these caps are in the form of interest rate caps and/or payment caps.  An interest rate cap determines the maximum number of percentage points your interest can increase over the life of the loan.

MORTGAGE PAYMENT ADJUSTMENT PERIOD:

The mortgage payment adjustment period is the agreed upon intervals at which the payments of principal and interest are changed.  The lender can either adjust the rate periodically and adjust the mortgage payment to reflect the change, or the lender can adjust the rate more frequently than the mortgage payment is adjusted.  For example, the loan agreement may call for the interest to be adjusted every six months, but the payment to be adjusted every three years.  This scenario could be a problem.  If in the interim between payment periods (3 years), interest rates have gone up or down too much, there will have been too much or too little interest paid on the loan by the borrower over that period of time, and the difference will be added to or subtracted from the loan balance.  When unpaid interest is added to the loan balance, it is called negative amortization.

MORTGAGE PAYMENT CAP:

A mortgage payment cap is the maximum allowable interest rate the lender can charge on your loan regardless of what happens in the market.  Depending on your particular loan program, this is a percentage (usually 5% to 7.5% annually) that can be added to your fully indexed rate if the market warrants moving that high.  For example, if your fully indexed rate is 8% and your annual cap is 6%, your loans life cap would be 14%.

Mortgage payment caps were designed to limit unrestricted increases by lenders and keep the borrowers payments at a manageable level.  Some lenders impose payment caps, some impose interest rate caps and some lenders use both.

NEGATIVE AMORTIZATION CAP:

A negative amortization cap limits the amount of negative amortization that can be reached on a loan.  When the cap is reached, the loan is re-amortized to a level sufficient to pay off the loan over the remaining term of the loan.

CONVERSION OPTION:

A conversion option on an adjustable rate mortgage is called a Convertible ARM.  A conversion option gives the borrower the option to convert their adjustable-rate mortgage to a fixed-rate loan.  Convertible Arm's normally have a higher initial interest rate (even the converted fixed rate will usually be higher).  You will usually have a time frame in which to convert the loan to a fixed rate.  For example, you might have to make your decision to convert the loan sometime after the first year and before the fifth year ends.  In most cases, there is also a conversion fee imposed on the borrower (for instance 1% of the total loan amount).

There are many different ARM programs to choose from with many available options.  If you are considering an adjustable-rate mortgage, we will be happy to explain your options to you and make sure you have the right program to meet your needs.

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