In our 20 hour SAFE course the chapter on NonTraditional Mortgage Loan Products still causes some students grief... especially the section about ARMs. So here is a synopsis that will help to get the basic concepts across!
An Adjustable Rate Mortgage (ARM) has a fixed interest rate at the beginning of the loan, then the rate changes to match what interest rates are doing in the open market.
The interest rate used for a loan is called the Index. Loans made by lenders are based on different indexes. Three common indexes are the LIBOR, COFI and CMT.
Generally, lenders get their profit from a loan through the margin. The margin is determined by the lender, who will make it competitive. The margin is always expressed as a percentage, as is the index return.
The index return and margin added together equal the Interest Rate.
So, let’s say the lender wants to make a 3% margin, and today’s LIBOR rate is 4% (the index return). The lender could offer this loan at 7% interest to a borrower. But, to be competitive he is only going to charge 5%. The lender does not necessarily use the margin plus index to come up with this initial rate; it is based on other factors and assumptions.
Furthermore, let’s say this will be a 3 yr. ARM. The 5% interest rate is good for the first three years of this loan. This is called the note rate, or the start rate or teaser rate.
Even though the borrower will only have to pay 5% interest the first three years, he will have to qualify for the loan (ie. have adequate DTI) based on the fully indexed rate of 7% (which was the prevailing interest rate [index and margin] established at consummation of the loan).
It is a U.S. mortgage industry standard that unless stated otherwise, the length of the loan will be thirty years. Therefore this loan is arranged so that the first 3 years are at fixed interest, followed by 27 years of variable interest. A 5 yr. ARM would be fixed for the first five years followed by 25 years of variable interest, etc. There are also 1, 2, 7 and 10 year ARMs.
Borrowers often take an ARM loan as a temporary measure and subsequently plan to refinance or sell the property before the rate adjusts. But remember these are thirty year loans.
The mortgage note for this loan will spell out exactly how the interest rate will be calculated at each adjustment after the first three years and may involve a lot of fine print! For an ARM loan the margin does not change. The index is the part of the calculation that changes (according to the prevailing trends in whichever index is specified).
After the first three years of this loan have passed, the interest rate can vary. But by how much? And how often can the rate change? These changes are restricted by the Interest Rate Caps.
Once again the lender sets the terms, and may offer numerous options the borrower can choose from at the time he applies for the loan. Typically there are three different caps and they are always expressed as percentages. For this 3 yr. ARM let’s say the caps are 2/1/6.
The first cap listed is called the Initial cap. This is how much the interest rate can change for the first time (and only the first time). At the beginning of year number 4, the interest rate may increase by as much as 2%. The original rate (the note rate) is 5%. When we add the initial cap of 2%, the maximum rate the borrower might pay in the 4th year is 7%.
The middle number is called the Periodic or annual cap, and it is 1%. This means the interest rate may increase by 1% per year. At the beginning of year number 5, the interest rate on this loan may increase to as much as 8%.
The last cap is the Lifetime cap. For this loan the lifetime cap is 6% which means the highest the interest rate can go is 6% over the initial rate. Simple math tells us that the highest the interest rate can be set on this loan is 11%. Here is how the calculation looks:
5% for the first 3 yrs + 2% 4th yr + 1% 5th yr + 1% 6th yr + 1% 7th yr + 1% 8th yr = 11%
(2+1+1+1+1 = 6% maximum lifetime cap + the original 5% rate = 11%)
Interest rate adjustments are applied in increments (usually 1/8th of one percent) and can go either up or down! If the index has fallen, the borrower’s interest rate may be reduced. But even if the rates have plummeted, the periodic cap will not drop the interest rate more than 1% in that year. The initial and periodic caps are applied both ways… up or down.
There is also a floor rate, under which the accumulated interest rate reductions cannot fall. The floor rate is explained in the note.
Sometimes you will see a loan described as a 3/1 ARM (or 5/1 or 2/1 etc.). The second number denotes the adjustment period. It is a time period not a rate cap. This notation signifies that this ARM adjusts yearly. Most ARMs adjust once a year on their anniversary date. A few ARM loans adjust every six months, or even conceivably every month, but these are quite rare.