Adjustable Rate Mortgages

What is an adjustable rate mortgage? Adjustable Rate Mortgages (frequently called ARMs) come in more varieties than you can imagine. These loan products were developed during the 1970’s (by the California Savings & Loan Industry). Banks love these products because they are the ultimate inflation protector – for banks. In a nutshell, here is how they work: Unlike fixed-rate loans, the interest rate on an ARM (at the beginning of your loan and periodically thereafter) is based on a margin (the lender’s profit) plus a published index such as LIBOR (an international inter-bank borrowing rate), 12-MTA (a 12-month US Treasury Securities average), COFI (the Federal Home Loan Bank's 11th District Cost of Funds Index), or others. The “index rate” plus the “margin” is often called the fully indexed rate. If the published LIBOR index is 5.361% and the Margin is 2.225%, then the fully indexed rate is 7.586%. The interest rate on your ARM will tend to increase over time to be not less than the fully indexed rate. The interest rate you actually pay is adjusted every six months or once a year.

When ARMs were first developed they totally favored the lender and there were almost no consumer protection devices. Nowadays most ARM programs have one or more “caps” that offer some (but not much) consumer protection. A payment cap protects you from your monthly payment going up too much at once. There may be a cap on how much your interest rate can go up in one period -- say, no more than two percent per year, even if the underlying index goes up by more than two percent. You may have a "payment cap," that instead of capping the interest rate directly caps the amount your monthly payment can go up in one period. In addition, almost all ARM programs have a "lifetime cap" -- your interest rate can never exceed that cap amount, no matter what.

What ARM Program is the best?

There is no good answer to this question because (i) it depends on your financial circumstances and (ii) the general trend of interest rates. If interest rates are in a downward spiral, then you will usually be pleased with any ARM program (and unhappy with most fixed-rate programs). If interest rates are in an upward spiral, then you will usually be unhappy with receiving notices from your lender that the interest payment on your home has increased (again). ARMs often have their lowest, most attractive rates at the beginning of the loan (sometimes called teaser rates), and those rates are guaranteed for periods ranging from one month to seven years. You may hear people talking about or read about what are called "3/1 ARMs" or "5/1 ARMs" or the like. That means that the introductory rate is set for three or five years, and then adjusts according to an index every year thereafter for the life of the loan. Loans like this are often best for people who anticipate moving and selling their home within three or five years, depending on how long the lower rate will be in effect.

Why would anyone choose an ARM?

Since ARMs offer inflation protection to lenders, the introductory (teaser) rates are usually lower than prevailing rates on fixed-rate loans. These teaser rates are often low enough to allow homebuyers to qualify for a bigger house or a larger loan. If you are in an ARM and rates are rising, you should (must) count on (i) moving and selling, (ii) refinancing at some time in the future or (iii) simply absorbing the higher loan rate. Interest rates are not always rising. If you are in an ARM and rates are falling, your ARM will allow you to have a slight advantage by pocketing more money each month that would otherwise have gone toward the payment of a higher fixed-rate loan.

What should all consumers know about ARMs?

Wow – that is a tough question. Your “friendly banker” will tell you that ARMs are the best things since sliced bread. However, we believe that ARMs are complex financial products that have many pitfalls. You need to have a good understanding about all of the pitfalls before you sign on the dotted line. The index rate is an important part of your ARM – so choose it carefully. For example, the COFI index offers more stability than the LIBOR index – but not all lenders offer a COFI index. For a short primer on ARM indexes (along with some great illustrations), take a look at www.moneycafe.com

The lender’s Margin is often negotiable – and can be reduced if you are willing (and able) to pay some up-front money (points). Rate adjustment frequency and “caps” are standard protection devices, but it is important to understand what they mean (or might mean) to you in absolute dollar terms. A lender’s loan disclosure document and related Annual Percentage Rate (APR) calculations assume that interest rates will not rise. Accordingly, you may need to calculate a few “what-if” scenarios. Most lenders simply will not do these what-if calculations because they speculate about the future.

Because of the inherent conflict of interest between lenders and consumers, we believe all consumers should consider using the services of a loan broker who has no financial “stake” in the lender. If you are thinking about obtaining a 3/1 ARM or a 5/1 ARM, most loan brokers will have (or can obtain) a product disclosure document from one of their “favorite” lenders. Your loan broker of choice should be able to help you read and understand this document before you decide that ARMs really are better than sliced bread.

After you have read and think you understand the product disclosure document, we think you should also ask your taxman and your financial advisor for their input about which ARM, if any, is best for you.

Written By:

Glynn Shaw, CEO of GRS Capital

949-369-1420

glynn@grscapital.com

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