Understanding Adjustable-Rate Mortgages

In this article, we provide an understanding of alternatives to the fixed rate mortgage including various types of adjustable rate mortgages.

For the past several years, fixed mortgage interest rates have been at historical lows therefore virtually no one explored Adjustable-Rate Mortgages (ARM). With the prospect of higher interest rates in the near future, folks will be tempted by alternative mortgage products. The Fixed Rate Mortgage is simple to understand. It has two basic components: the interest rate and the mortgage term. The interest rate is fixed for the term of the loan. A 3.5% fixed rate for 30 years means the monthly payment will remain fixed for 360 payments at which time the loan balance will be zero.

The 30-year Fixed Rate Product has the Highest Rate.

Other Mortgage Products Can Offer a Lower Interest Rate.

Adjustable-rate loan products are not simple to understand. They are at best confusing to even seasoned mortgage professionals. Consumers should approach these mortgage products very carefully and do some research.

As always, our goal at AskChristee is to provide information so you can make smart home buying decisions.

Alternatives to Fixed Rate Mortgages

One year ARM (Adjustable-Rate Mortgage)

ARMs are also referred to as variable-rate mortgages. The interest rate for ARMs is fixed for a period of time. A 1/1 or one-year ARM means the interest rate is fixed for one year. A 5/1 ARM means the interest rate is fixed for 5 years. This may be referred to as the ‘Initial Interest Rate Period’

Once the initial fixed-rate period ends, the interest rate will be reset every year.

The formula for the interest rate reset is:

Index + margin = fully indexed rate. (New rate subject to interest rate cap.)

Index. For an adjustable-rate mortgage, the index is a benchmark interest rate that reflects general market conditions. This is similar a lease where future rent increases are tied to the ‘Cost of Living’ index.

Typical indexes, for ARM loans, include the Prime Rate, the London Interbank Offered Rate (LIBOR), the Secured Overnight Financing Rate (SOFR), or the rate on short-term U.S. Treasuries (T-Bill).

The index is set by the Lender and the borrower has no control of the ‘index’ used for the ARM loan.

Margin. The borrower does a say in the ‘margin’ which can be the most important component of an ‘ARM’ loan. In theory, the borrower and the lender agree on the margin. However, in practice very few borrowers realize the margin can be negotiable.

The amount of the margin can be another source of profits to a Lender when selling the loan. In some circumstances, a higher margin is imposed due to the borrowers’ credit score. However, part of the lender’s revenue could be based upon the margin. A higher margin is good for the lender and NOT good for the consumer.

Interest Rate Cap. Most ARM loans offer some protection, to the borrower, to soften the effect of future rate increases. A typical ARM will offer some combination of the following ‘Caps’.

  1. Initial Interest rate cap. An initial interest rate cap is the maximum amount that the interest rate on an adjustable-rate loan can increase at the first scheduled rate adjustment. This is a safeguard against payment shock in the initial phase of a ARM loan.
  2. Subsequent interest rate cap. A cap on annual interest rate change. Typically, the annual cap will be 1 to 2%. If margin plus index would indicate a new rate of 6% and the previous year’s interest rate was 3.5% then the new rate would be capped at 5.5% (3.5% plus 2% annual cap).
  3. Lifetime time interest rate cap. A fixed amount which when added to the initial rate set the maximum the interest rate for life of loan. If the year rate is 3% and the life cap is 5% then the max rate you could experience would be 8%. Typically, lifetime interest rate caps are between 5 and 6%.
  4. Payment Cap. The monthly payment is capped at adjustment period(s) notwithstanding the fully indexed interest rate. In theory, this can provide great comfort to the borrower, however, it may also lead to unintended consequences like negative amortization. See ‘Negative Amortization’ for better understanding.
  5. Carry Over Interest occurs when the fully indexed rate (potential new interest rate) is not realized due to annual interest cap. For example, if the index plus margin would indicate a new rate of 6% for the third year. However, the new rate is capped at 5% and there is a 1% carry over rate. This carry over rate is available to be utilized at the next adjustment period. It at the next adjustment period the index plus margin would indicate a rate of 5% or no change in the interest rate, the ‘carry over rate’ would be imposed and the new interest rate will be 6% for the fourth year.

Pros for One-Year Adjustable Loans

  1. Allow for lower payment in early years when compared to the fixed rate product.
  2. May allow for qualifying for a more expensive home.

Cons for One-Year Adjustable Loans

  1. Interest rate may adjust higher resulting in higher monthly payments.
  2. May induce the need to refinance (costs money) when interest rates decline.

Hybrid ARMs

Hybrid ARMs often are advertised as 3/1 or 5/1 ARMs—you might also see ads for 7/1 or 10/1 ARMs. These loans are a mix—or a hybrid—of a fixed-rate period and an adjustable-rate period.

The interest rate is fixed for the first few years of these loans—for example, for 5 years in a 5/1 ARM. After that, the rate may adjust annually (the 1 in the 5/1 example), until the loan is paid off.

In the case of 3/1 or 5/1 ARMs, the first number tells you how long the fixed interest-rate period will be, and the second number tells you how often the rate will adjust after the initial period.

You may also see ads for 2/28 or 3/27 ARMs—the first number tells you how many years the fixed interest-rate period will be, and the second number tells you the number of years the rates on the loan will be adjustable. Some 2/28 and 3/27 mortgages adjust every 6 months, not annually.

The Hybrid loans, after the initial fixed period, adjust in the same manner as a One-Year- Adjustable-rate product.

7/1 ARM. The loan allows for a fixed rate for the first seven years thereafter the interest will become variable (not fixed). The first number, in this example ‘7’ refers to the fixed interest rate period. The second number tells us the adjustment period after expiration of the fixed period. The ‘1’ (7/1) tells us that after 7 years the loan becomes a one-year adjustable-rate loan. The interest rate will adjust every rate for the remaining term of the loan.

Other variations of this concept are 3/1,5/1 or 10/1 loans.

Pros and Cons of a Hybrid Loan

Pros: The interest rate is generally slightly lower interest than a ‘Fixed Rate loan’.

Pros: A good product if you know you will be relocating and are not looking for the security of a long-term fixed rate loan.

Cons: After the fixed period, the interest rate will change every year. See One-Year-Adjustable for better understanding of future interest rate changes.

Cautionary Aspects for ARM loans.
Qualifying Interest Rate
Lifetime Interest Rate Caps
Annual Interest Rate Caps
Annual Payment Limits
Carry Over Interest Rate Provisions
The Margin Amount
You Should Fully Explore Each of these Items with the Lender

Balloon Mortgages

This mortgage products offer a fixed rate for a period of time then the principal balance becomes payable in full – hence a ‘balloon payment’.

Reset to Fix rate option. The balloon product may an option to convert into a fix rate or ARM at the end of initial period – 5 or 7 years. If available, this is a one-time option otherwise the loan becomes due and payable.

Pros of Balloon Mortgage

  1. May offer a lower interest rate
  2. May qualify for more expensive home

Cons of a Balloon Mortgage

  1. Will be required to pay balance in full.
  2. May require refinancing or selling the property.

Qualifying Rates for ARM Loans

The qualifying rate is the interest rate used to establish the total monthly payment and thus the qualifying ratios – either payment or debt-to-income ratios. Over the past couple of decades, the climate has changed in setting the qualifying rate for adjustable-rate loans. There was a time when the first year (start rate) was used in qualifying for an ARM loan. This allowed borrowers to qualify for a more expensive home, however, it also increased the likelihood that borrowers could not afford the future payment should rates increase on the adjustable-rate loan.

For Hybrid products like a 5/1, 7/1 or 10/1 lenders will typically use the note rate (start rate) but they might add two percent to the qualifying rate of a 3/1 applicant.

For one year ARM loans lenders use the “fully-indexed rate,” which is the rate your loan would be if it were adjusting today based on its terms – this would be the ‘index’ plus the ‘margin’. Other lenders may use the start rate plus the margin.

You should check with lenders but also be cautioned against qualifying at a very low interest rate.

Interest Only Mortgage. The interest only mortgage requires a payment of interest only without any required payment to amortize (reduce) the loan balance. The principal balance remains the same regardless of the term of this loan type. If you make interest only payments on a $100,000 for ten years, after ten years you still owe $100,000.

Example Interest Only Payment: $100,000 loan at 5% for 30 years requires a principal and interest payment monthly of $ $536.82. An interest only payment would be $416.67.

Pros of Interest only payment.

You make a smaller monthly payment.

May qualify for a slightly more expensive home.

Cons of interest only payment.

  1. Period for interest only period is usually fixed to a given period of time. At the end of this period, you will need to either refinance or sale the property.
  2. No principal reduction thus less (or no) equity in the property.

Negative Amortization and ARM Mortgage

Negative amortization means that the amount you owe increases even when you make all your required payments on time. It occurs whenever your monthly mortgage payments are not large enough to pay all of the interest due on your mortgage—meaning the unpaid interest is added to the principal on your mortgage and you will owe more than you originally borrowed. This can happen on an adjustable-rate loan because your loan has a payment cap.

Because payment caps limit only the amount of payment increases, and not interest-rate increases, payments sometimes do not cover all the interest due on your loan. This means that the unpaid interest is automatically added to your debt, and interest may be charged on that amount (compound effect by increasing the principal balance). You might owe the lender more later in the loan term than you did at the beginning.

A payment cap limits the increase in your monthly payment by deferring some of the interest. Eventually, you would have to repay the higher remaining loan balance at the interest rate then in effect. When this happens, there may be a substantial increase in your monthly payment. Some mortgages include a cap on negative amortization. The cap typically limits the total amount you can owe to 110% to 125% of the original loan amount. When you reach that point, the lender will set the monthly payment amounts to fully repay the loan over the remaining term. Your payment cap will not apply, and your payments could be substantially higher. You may limit negative amortization by voluntarily increasing your monthly payment. Be sure you know whether the ARM you are considering can have negative amortization.

Should You Choose ARM Loan?

That could depend upon many factors. We will highlight some of the reasons to consider an ARM.

  1. If there is substantial difference between a 30-year fix rate and a Hybrid loan (3/1 or 5/1) then the Hybrid could make sense. This is especially true if you plan to relocate in the near future.
  2. If you’re confident in your future earning and you want to buy a nicer home now.
  3. Buying a starter home, which you plan to sell in the foreseeable future.
  4. The ARM product may allow you to buy in a more desirable community which may offer additional appreciation.
  5. If you are a risk taker and are willing to gamble on future interest rates.
  6. You feel confident that interest will be lower in the future.

Expert Forecast on Mortgage Rates are Almost Always Wrong.

Running AskChristee Modules with Adjustable-Rate Loans

For ‘Buyer PreQual’ or ‘Buyer Choice’, Enter Qualifying Rate as the Interest Rate.

For 3/1, 5/1, 7/1 or 10/1 Loans, Enter the Start Rate as Interest Rate

For One-Year Adjustable Loan, Enter the Start Rate plus 2 or Margin whichever is Less