Adjustable Rate Mortgage Loans - The How's, the Who's and the Why's

If you're shopping for an Adjustable Rate Mortgage Loan, and a 6% 30-year Fixed Rate Mortgage Loan isn't all that appealing (or maybe it doesn’t fit your budget), the you should investigate the possibility of an Adjustable Rate Mortgage (ARM’s) - especially a Hybrid Mortgage Loan. You'll be in good company: some 34% of all mortgage loans are now being created, feature some form of an Adjustable Rate feature. "But I don't like having an Adjustable Rate, I would prefer a Fixed Rate," you say. "I don’t understand Adjustable Rate Mortgage Loans, they're confusing, and uncertain, and my payments will go might increase."

That is not always true - if you understand how Adjustable Rate Mortgages work, and how to use them to your advantage. We've drafted a simple educational guide to help you to make a better educated decision on whether or not any an Adjustable Rate Mortgage is for good you.

Many Adjustable Rate Mortgages aren't priced or structured for sale in what is called the secondary mortgage market, which is where all mortgage loans are pooled together and then sold to investors. Now, because many mortgages are put together as "portfolio products", that is, to meet the mortgage lender's own needs, there can be a much greater flexibility in how these loans are priced and therefore offered to you. You might also find somewhat more liberal and easier qualifying terms.

Adjustable Rate Mortgage Basics

Adjustable Rate Mortgages are simply a short-term fixed rate mortgage loan. The longer the fixed interest rate period, the higher the interest rate you'll pay for that time period. For example, a 1 year Adjustable Rate Mortgage generally has a higher interest rate than does a 6 month Adjustable Rate Mortgages. A true 3-year Adjustable Rate Mortgage, where the rate adjusts every 3 years, has a higher interest rate than does the 1 year variety, and so on, so forth.

The starting rate for Adjustable Rate Mortgage is usually priced at a discount from the index + margin formula. This introductory rate (which is usually referred to as a teaser rate) is an incentive for you to take an Adjustable Rate Mortgage. Real "teaser" Adjustable Rate Mortgages, by definition, usually have a starting mortgage interest rate below that of the current value of the index which governs the Adjustable Rate Mortgage market, and are increasingly rare in today's very low rate environment.

Additional information on Adjustable Mortgage Loan Programs can be found here.

Read here for more information on Adjustable Mortgage Loan Programs

Mortgage Rate Indexes

Adjustable Rate Mortgages come in many varieties, but they mostly work the same way. At the end of the fixed rate period, the interest rate is changed in accordance with the value of a specified economic indicator, called an index. While there are many different indexes that are used to govern Adjustable Rate Mortgages, the most common types are the following:

Treasury Constant Maturities (also called Treasury Securities, or TCM) - the most common Index; used on 1 year Adjustable Rate Mortgages and Hybrid Adjustable Rate Mortgages.
Treasury Bills - mostly used for 3 month and 6 month Adjustable Rate Mortgages.
11th District Cost-of-Funds (also called COFI, pronounced 'coffee') - used mainly on 1 month and 6 month Adjustable Rate Mortgages.
London InterBank Offered Rate (LIBOR, pronounced 'lye-bore') - used mainly on 1 month and 6 month Adjustable Rate Mortgages, and some annual Adjustable Rate Mortgages.

There are also several other varieties of mortgage indexes, including those generated using a so-called moving average of a number of weekly and/or monthly values, and those contrived by only specific mortgage lenders.

When the Adjustable Rate Mortgage rate is adjusted, the mortgage lender (or servicer) finds the value of the current mortgage index, and adds a markup, known as a the margin. Generally, the total of your index plus margin equals the interest rate you'll be charged for the next fixed period term, however long that may be according to the terms of that particular Adjustable Rate Mortgage.

Adjustable Rate Mortgage Caps

To protect you from large interest rate increases, most Adjustable Rate Mortgages feature some form of max limitations on how much your interest rate can adjust froma fixed period to a fixed period. These limitations are called mortgage caps or rate caps. You may hear them referred to as two and six caps; they may also be called periodic and lifetime caps, per-adjustment and life caps, and so on so forth. Although many kinds of interest rate cap structures are possible, the most common kinds of mortgage loan caps limit your change at any one time period to two percentage points, and a total of six percentage points over the life of the loan. In many cases, these mortgage rate caps also restrict how low your rate can go.

For example, if you have a 1 year Adjustable Rate Mortgage Loan with a 2% per adjustment cap, and you're paying 6%, the worst you would possibly see next year would be 8% (the best, 4%). Your periodic cap limits the increase - no matter what the index plus margin add up to.

Here's a better example or a scenario:

You have a 1 year Adjustable Rate Mortgage at 5.75% for the first year. The year comes to an end. The mortgage lender takes the value of the index (for example, 5.00%) and adds a margin of 2.75% to arrive at your new mortgage interest rate. So, the calculation is structured like this: 5.25% + 2.75% = 7.75%

But wait a minute. There is a limit on how much your rate can increase at any one given time. Your current interest rate, plus your cap, is the maximum that it can be increased under the terms of the contract:

Current Rate + Current Cap = Maximum New Interest Rate (for this increase)

Which calculates as 5.25% + 2.00% = 7.25% (maximum new rate)

Your current mortgage interest rate is 5.25%, and your cap is two percentage points. 5.25% + 2.00% = 7.25%, and your mortgage interest rate cannot move increase any higher than 7.25%, so that's what the new interest rate would become.

What happens to the difference you might wonder? Except in very rare circumstances, the rest is simply discarded. This is the risk that the mortgage lender or investor takes in lending money in an Adjustable Rate Mortgage; while the benefit is in the fact that the interest rate will change of course change with the market conditions, they may or may not get the maximum value from their investment dollar.

Some Adjustable Rate Mortgages, such as a Hybrid Adjustable Rate Mortgage, have limited (or no) caps to limit movement at the very first adjustment.

Have a Heartland Financial Corporation Representative contact you today.

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Common Adjustable Rate Mortgages

Adjustable Rate Mortgages come in a variety of adjustment periods - monthly, every three months, every six months, annually and every three years (in addition to many others).

What you need to know about Monthly Adjustable Rate Mortgages

Usually based on the 11th District Cost of Funds Index (COFI), London InterBank Offered Rate (LIBOR), or a Moving Average of monthly values of 1 year Treasuries (called MTA or sometimes 12-MAT) these Adjustable Rate Mortgages typically feature a very short initial fixed interest period, usually 3 or 6 months. After the initial fixed period, the interest rate moves up and down along with changes in the mortgage market index. The monthly mortgage payment fluctuates, too. However, the COFI is perhaps the slowest moving mortgage market index, changing by only small fractions of a percent at one time. For Example, in 1999, the COFI index moved an average of 0.031% each month (just 3 basis points). On the other hand, the 1 year Treasury moved about 0.092% each month - an average of nearly three times the volatility.

Because the COFI barely moves, there are generally no "per-adjustment" caps that govern these interest rate changes each month, but there is a lifetime cap, typically 5.00%. Instead of a periodic interest rate cap, a COFI ARM may have a "payment cap", a feature where the mortgage payment cannot increase more than a pre-determined amount from year to year, usually 7.5%. That is, if your mortgage payment in year one is $100 per month, your payment in year two will be no more than $107.50 per month.

Here's an example: The mortgage index has been slowly rising, and your monthly mortgage payment, which started the year at $100, is increasing along with it - and is now at $107.50 each month. Your monthly budget is starting to feel a little tighter and here comes this month's mortgage payment, with another small increase to $108.25. Your mortgage lender will usually now give you an option, either send in only $107.50 (the minimum payment due) or send in $108.25 (the actual amount due). You send in the $107.50, since money's a little tight. What happens to the other 75 cents?

Unlike the rate-capped Adjustable Rate Mortgages, the difference between your actual monthly mortgage payment and the larger mortgage payment isn't discarded. It is added back onto what the principal balance that you owe, which is a process called negative amortization. The following month, you'll be charged interest on that additional 75 cents you 'borrowed', since the mortgage loan balance you still owe just increased by the 75 cents you didn't pay in this months payment. If the process goes on for a long period of time, you could end up owing more than you initially borrowed.

Why would anyone want such a mortgage loan? Well, it's one way to keep your monthly budget intact in a time of increasing mortgage interest rates. Also, if you we’re thinking of selling your home, it can help keep your cost of ownership down, especially if home values are increasing enough to offset any additional money you owe when the home is sold. Because the COFI Adjustable Rate Mortgage moves so slowly, you're less likely to be affected by the kind of spike in rates than can happen with a TCM-based Adjustable Rate Mortgage.

What you need to know about Monthly Adjustable Rate Mortgages

Traditional Adjustable Rate Mortgages have interest rates and monthly payments that adjust at fixed and regular intervals. For years, the most popular and most widely offered kind was the 1 year Adjustable Rate Mortgage, which has an interest rate that changes once a year. There are varieties of traditional Adjustable Rate Mortgages that adjust in 6 month, 1 year, 3 year and even 5 year intervals (although true 5 year Adjustable Rate Mortgages are rare these days).

Most traditional Adjustable Rate Mortgages with interest rate adjustment periods of one year or longer rely upon the Treasuries to govern their changes, but varieties of LIBORs are growing in popularity. Typically, for example, a 1 year Adjustable Rate Mortgage is keyed off the 1Year TCM, 3 year Adjustable Rate Mortgage off the 3 Year TCM, and so on, so forth.

Traditional Adjustable Rate Mortgages with regular adjustment periods of 1 year or less may rely on a number of mortgage indexes to govern their adjustments. For monthly, 3 month and 6 month Adjustable Rate Mortgages, investors may use Treasury Bills, which come in 1 month, 3 month and 6 month terms. You may also find that these short term Adjustable Rate Mortgages sometimes use the 11th District (or other) Cost of Funds Index (COFI), or may use the London InterBank Offered Rate (LIBOR) as their index. Why would an investor use a LIBOR, an offshore rate roughly equivalent to our Federal Funds Rate, as an index for an American Adjustable Rate Mortgages? It simply makes the loan, or portfolio of loans, easier to sell to offshore investors. Aside from these, there are also contrived indexes, like the Moving Treasury Average (MTA), or the so-called Federal Cost of Funds (Fed COF), which averages all outstanding Treasury notes and bonds to arrive at a value.

Have a Heartland Financial Corporation Representative contact you today.

Start Here - Click here to Apply Online for an Adjustable Rate Mortgage Loan

Index Confusion: The Name Game

To confuse the index matter, many discussions of Adjustable Rate Mortgages focus around the "1 year Treasury Bill". There is such a thing as a "12 Month Treasury Bill," but it's rarely used as an index on any Adjustable Rate Mortgage. The Bill is auctioned only once per month, which makes it easy to discern from the commonly-used Treasury Constant Maturity, which has both a weekly and a monthly value. So, if someone tells you the mortgage index is the "weekly average of the Treasury Bill" you know that can't be right - it must be the Treasury Security index. The best way to be certain is to read the actual terms of the Adjustable Rate Mortgage contract; the proper information will be located in the Note or Adjustable Rate Rider which accompanies it.

Hybrid Adjustable Rate Mortgages

Among the most popular Adjustable Rate Mortgages today are so-called Hybrid or 'delayed first-adjustment' Adjustable Rate Mortgages. These Adjustable Rate Mortgages feature a fixed interest rate for a period of years -- commonly 3, 5, 7 or 10 years - before they turn into a traditional 1 year Adjustable Rate Mortgage for the remainder of a 30-year term.

The fixed interest rate period is not governed by any index or margin, and mortgage lenders have some leeway to price the products to meet their standards. This means that when shopping, you may find a wide range of interest rates being offered. For example, a recent weekly survey by HSH pegged the range of interest rates available for a conforming 7/1 Adjustable Rate Mortgage from 4.750% to 6.725% across the country. By way of comparison, this is a larger spread from high-to-low than ever was found for the same week for the similar 30 year fixed rate mortgage loan.

The Hybrid Adjustable Rate Mortgage makes for an interesting alternative to a normal fixed rate and a traditional adjustable rate mortgages, because it allows the borrower to choose how much fixed rate and how much adjustable rate mortgage he or she wants. Like traditional Adjustable Rate Mortgages, the mortgage interest rate you'll pay increases along with the increase in the length of the fixed period term. This means that a 3/1 Hybrid Adjustable Rate Mortgage has a lower interest rate than a 5/1, which has a lower rate than a 7/1, which in turn has a lower rate than does a 10/1 Adjustable Rate Mortgage.

A special note about "caps" for Hybrid Adjustable Rate Mortgages: Most Hybrid Adjustable Rate Mortgages have an additional layer of interest rate limiter, called the "first adjustment cap", which applies only after the fixed rate period of the Hybrid Adjustable Rate Mortgage comes to an end. Thereafter, typical "periodic" caps will apply.

However, that first adjustment cap may provide little or virtually no protection against a volatile interest rate environment.

First adjustment caps on Hybrid Adjustable Rate Mortgages can provide some rate-change limits, as in the case of a 2/2/6 cap structure (no more than a 2 percentage point change to your existing mortgage interest rate at the first adjustment); considerably less protection, as in a 5/2/6 cap arrangement (your interest rate can jump as much as five percentage points at the first initial change) or no real protection at all, where your interest rate can climb all the way to the maximum allowable interest rate (a 6/2/6 cap). There are also caps structures of 5/2/5, 2/2/5 and other arrangements. Be aware that mortgage lenders may offer any or all of the above cap arrangements on Hybrid Adjustable Rate Mortgages, so it's completely up to you to ask about them, especially if you believe that sharply higher mortgage interest rates in the future might cause you a financial hardship. In some cases, your choice of cap structures will influence the interest rate you can be qualified for, but you might prefer a slighty higher interest rate today for more protection tomorrow.

Why an Adjustable Rate Mortgages at All?

You may not know that Adjustable Rate Mortgages are a fairly recent addition to the mortgage industry menu. When the Adjustable Rate Mortgages were first introduced about 20 years ago, fixed rate mortgages were at or near then-record highs of 15.50% to 19%. With fixed rate mortgages at an unaffordable level, the housing markets were threatened to come to a screeching halt. The earliest Adjustable Rate Mortgages were intricate, and confusing, especially to the borrowers who were used to the simplicity of a fixed rate mortgage. Worse, the prototype Adjustable Rate Mortgages featured no caps, and interest rates were considerably more volatile than now; in 1981 the 1 year Treasury frequently adjusted by more than one percent per week.

In addition, early Adjustable Rate Mortgages were priced with interest rates equal to - and sometimes above - comparable fixed rate mortgages. Given the very real threat of payments increasing even higher, the early Adjustable Rate Mortgages weren't much of a hit in the industry.

The second generation of Adjustable Rate Mortgages was much better improved. They featured caps and introductory (teaser) interest rates. Borrowers took another look, and found that they were good changes to the product: mortgage interest rates were so high that they were most likely destined fall in the near future, and mortgage lenders were very happy to make these mortgage loans and collect interest payments again. At one time, Adjustable Rate Mortgages made up some 75% or more mortgages.

In the years that followed, many mortgage products came and left, but Adjustable Rate Mortgages remained. Hybrid Adjustable Rate Mortgages joined the scene in the late 80s, meeting a desire of the jumbo mortgage market. Since the conception of Adjustable Rate Mortgages, their appeal wasn't universal, but borrowers with certain characteristics have been inclined to choose them over fixed rate mortgages.

Which Borrowers Prefer Adjustable Rate Mortgages?

Originally, borrowers were drawn to Adjustable Rate Mortgages not only because of the lower available interest rates, but because they couldn't qualify for the traditional fixed rate mortgage they really wanted. Short-term Adjustable Rate Mortgages became so popular with those who liked the opportunity for a lower interest rate down the road, and among jumbo borrowers who wanted to maximize their positive cash flow for more productive investments. Longer term Adjustable Rate Mortgages found favor among those who feared the frequent interest rate changes and the uncertainty they brought to a income budget.

Additional information on Adjustable Mortgage Loan Programs can be found here.

Read here for more information on Adjustable Mortgage Loan Programs

How can you decide whether an Adjustable Rate Mortgages is for you or not?

The best way is to match up your time frame, whatever this may be, against the fixed term of your loan and the costs of having the loan over that term period. For example, short-term Adjustable Rate Mortgages fit short term time periods. If you're an executive who gets transferred often, why pay for a long term traditional fixed-rate mortgage when the odds favor you'll be relocating in the next few years? If you're convinced that mortgage interest rates are high today, and if you're willing to risk that they'll be lower next year or even the year after that, you might be drawn to a short term Adjustable Rate Mortgage.

Maybe you're just willing to gamble that the mortgage interest rates won't rise much more either, so a monthly Adjustable Rate Mortgage might be perfect for you. A low introductory interest rate, a little increase in rates, and a slow, steady climb might fit you better than the unpredictable nature of a 1 year TCM Adjustable Rate Mortgages. You may be able to benefit from an interest rate that is better than the available fixed rate for a good while, and save yourself some money, while not exposing your income budget to too much of an interest rate risk.

There were (and still are) borrowers who want to take short-term Adjustable Rate Mortgages of a year or less, and then refinance if and when the interest rate they receive at the first adjustment isn't acceptable. Essentially, they get a low cost fixed rate mortgage loan with an interest rate as much as two percent below the comparable 30 year fixed rate mortgage. If the closing costs and fees are low enough, they get all their money invested back and then some each and every following year, all while paying down their mortgage loan a little bit faster than if they had selected a fixed rate mortgage loan. The lower interest rate means they’ll pay down the principal mortgage loan balance slightly at a slightly faster rate, leading to reduced interest rate charges.

For example, after one year, a $100,000 fixed rate mortgage loan at 8%, will have cost $7,970 in interest, and will still owe a principal balance of$99,165. After the first year with a 1 year Adjustable Rate Mortgage at 6.25%, you'll only pay $6,217 in interest and only owe $98,828 in mortgage principal. You would refinance to a new low introductory interest rate, and start all over again. This plan is probably a bit too much work for the average homeowner and usually can result in prepayment penalties that may negate any benefit.

Is an Adjustable Rate Mortgage Loan Right for You?

If you haven't considered an Adjustable Rate Mortgage before, you certainly should now consider them. The following short checklist will help you to understand and choose if some form of an Adjustable Rate Mortgage is right for you:

My job has required more than one transfer in the past ten years.
I bought or intend to buy a starter home.
I'm single, young and buying a condo, town home or apartment.
I'm a potential retiree in the next 8 years.
I think rates will fall in the near future
I have trouble qualifying for a fixed rate mortgage loan at today's rates.
I expect to move or expand my home within 7 years.
I'm getting a jumbo mortgage loan.
I am responsible and care for my elderly relatives.

A checkmark on at least any of these questions tends to indicates that you probably won't be wanting a 30 year fixed rate mortgage anywhere near 30 years. You may expand your home, move, refinance, retire and move or want a more positive monthly cash flow. All of these argue in favor of some form of an Adjustable Rate Mortgage.

Last and Final Word

Remember this; your mortgage loan is a kind of reverse investment. Like any other investment plan, you should have an idea of how you want your investment to perform over a certain period of time, in order to reach your maximum goals. There are many different investment options, each of them performing slightly different, each with a set of different risks and benefits. Just as the right investment for your personal needs can make you money, choosing the right mortgage loan for your needs can also save you money.

Specializing in Adjustable Rate Mortgage Loans in these areas:

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