Those in an Adjustable Rate Mortgage (ARM) due to adjust this year have a lot of company. Many home-buyers used ARMs in order to qualify for their home purchase in the early to mid 2000’s.

Commonly, adjustable rate mortgages were used because the initial payments were lower than the equivalent fixed-rate mortgage payments. This brought the borrower’s debt-to-income ratio within the qualification range suitable for their home purchase mortgage, otherwise unattainable with a traditional fixed-rate mortgage payment.

Others chose adjustable rate mortgages simply for the lower initial payment, planning to refinance before their mortgage rate and payment adjusted upward.

How Do Adjustable Rate Mortgages
(ARMs) Work?

If you are currently in an ARM, you are most likely concerned with what your mortgage payment is going to be after it adjusts, and how adjustable rate mortgages really work. Many, if not most borrowers in an adjustable rate mortgage , really don’t even know what their ARM Terms are. We will cover the various parts that make up adjustable rate mortgages so that you will be able to better assess your future payments.

Your current mortgage “adjustable rate rider” will have all the information you need to take the mystery out of your adjustable rate mortgage. This rider should be included with the mortgage paperwork provided by your mortgage lender when you took out the loan. If you cannot locate the adjustable rate rider, you can get a copy of it at your county office where mortgages are filed (it is filed with the county right along with your mortgage paperwork). Of course, you can always call your lender to get a copy of your adjustable rate rider.

Information Needed To Evaluate an Adjustable Rate Mortgage

Adjustable rate mortgages, or “ARM’s” are home loans in which the mortgage rate changes periodically according to the terms of the home loan program. Compared to a fixed-rate mortgage, there is usually a lower mortgage rate to start, but the interest rate is normally adjusted upward at periodic times.

You should know the following aspects of your current or future (get the terms spelled out if you are looking at an ARM) adjustable rate mortgage.

The Index to which your ARM Rate is tied: Lenders base the future mortgage rate on an index and then add a set “margin” to the index rate on the adjustment date to calculate the new interest rate. The most common indices are the US Treasury Bills, California's 11th District Cost of Funds (COFI), and the London Interbank Offered Rate (LIBOR).

The Initial Interest Rate: This is the initial mortgage rate quoted with the ARM.

The Period for which the Initial Interest is Fixed: The initial fixed-rate period can range anywhere from one month to 7 years or more, depending upon the specific program.

The Rate Adjustment Period after the Initial Fixed-Rate Period is over: On ARMs with initial mortgage rate periods of 1 year or longer, this is almost always 1 year. On ARMs with initial interest rate periods shorter than 1 year, the subsequent rate adjustment period is almost always the same as the initial rate adjustment period.

The Margin that is added to the Index Value on a Rate Adjustment Date to determine the New Rate: This generally ranges from 2 to 3%.

The Rate Adjustment Cap limiting the Size of the First Rate Adjustment: This generally ranges from 1 to 5%.

The Rate Adjustment Cap limiting the size of Subsequent Rate Adjustments: This generally ranges from 1 to 2%.

The Maximum Interest Rate over the Life of the Loan: This is usually 5 or 6% above the initial mortgage rate.

How Do I Determine My Rate After
The Initial Fixed Period Ends?

The rate after the initial fixed period ends will be equal to the interest rate of the ARM’s tied-in index plus the margin, also know as the “Fully Indexed Rate”.

1) An Example when the “Fully Indexed”
rate is Greater than the Initial Rate
at the First Rate Adjustment

The only exceptions being that the Fully Indexed Rate at the first rate adjustment cannot exceed the:

• Initial Mortgage Rate plus the Rate Adjustment Cap
• Maximum Allowable Mortgage Rate for that particular ARM program.

In the first example, the fully indexed rate of 7.5% is less than the initial rate plus the adjustment cap, and also less than the maximum rate, so the new rate is 7.5%

The second example shows that the fully indexed rate of 7.0% is greater than the initial rate plus the adjustment cap, so the lower rate of 6.5% is used.

In the third example, the fully indexed rate of 11.00% and the initial rate plus adjustment cap are greater than the maximum rate allowed for the ARM, so the resulting rate is 10%

2) An Example when the “Fully Indexed”
Rate is Less than the Initial Rate
at the First Rate Adjustment

When the Fully Indexed rate is less than the initial mortgage rate, the new rate is determined by the higher of the:

• Fully Indexed Rate
• Initial Mortgage Rate less the Rate Adjustment Cap
• Minimum Allowed Mortgage Rate for that particular ARM program

In the first example, the Fully Indexed Rate is higher than the initial rate less the rate adjustment cap, and less than the minimum rate, so a 5.50% results.

The second example shows that the Initial Rate less the rate adjustment cap is greater than the fully indexed rate and the minimum rate, which results in a 5.00% rate.

In the third example, the Minimum Rate is greater than the initial rate less the rate adjustment cap, and the fully indexed rate, so you end up with a 4.75% rate.

How Are Mortgage Rates Adjusted
After The First Adjustment?

The period until the second mortgage rate adjustment does not have to be, and frequently is not the same as the first adjustment period. For instance, most 5 Year ARMs are fixed for the first five years and then adjust Every Year after the First Rate Adjustment.

Mortgage rate adjustments after the first adjustment follow the same rules as the first adjustment, except that the rate adjustment cap applies to the change from the preceding mortgage rate rather than from the initial mortgage rate.

Should I Avoid Adjustable Rate Mortgages?

Now, it may seem that an adjustable rate mortgage is a risky deal on the surface, but they can be advantageous in certain situations. ARM’s are often considered by people in the process of restoring credit scores, expecting an increase in future income, or are planning to move within a set number of years. The individual takes advantage of the initial lower mortgage rate period and later sells their home or transfers to a fixed-rate home loan before the mortgage rate adjusts upward.

Pre-Payment Penalties

You want to know if your home loan has a prepayment penalty period and the details of the penalty amount attached to your loan.

If a prepayment penalty applies, the penalty occurs if you pay off your home loan or refinance into another mortgage before the predetermined time period expires.

For instance, suppose you take out an adjustable rate mortgage that is based on a 30 year repayment schedule, with your initial mortgage rate remaining fixed for three years. Your interest rate will begin to adjust after the initial three years, but you plan to refinance into a fixed-rate mortgage after two years. If your loan’s prepayment period is set at one year, you are good to go with no penalty.

On the other hand, if the prepayment period is set at three years or more, you will have to pay the penalty if you refinance just after the second year into the home loan. Typical penalties can range anywhere from 1% to 5% of the current loan value, so you want to pay close attention to the prepayment penalty details for your mortgage.

It should also be noted that some mortgage lenders waive the prepayment penalty fee if the borrower sells the home as opposed to refinancing it, and numerous states have passed laws and issued regulations that prohibit or restrict the use of prepayment penalties.

Provided the prepayment period does apply to your particular mortgage, you should ask your lender under what conditions, if any, will the prepayment penalty be waived.

Deciding on a Fixed-Rate Versus
Adjustable Mortgage (ARM)

Sometimes there is very little difference between an Adjustable Rate Mortgage and a Fixed Rate mortgage. If you are being quoted an ARM mortgage rate, always ask what the same loan program rate is for a Fixed rate mortgage. You may be surprised that the difference in mortgage rate amounts to just a few dollars a month and makes the adjustable rate mortgage a less than attractive option.

Depending upon short-term interest rates, specific mortgage programs, and overall economic conditions, there may be times when the adjustable rate mortgage option is significantly less than a fixed rate mortgage. In this instance, the adjustable rate mortgage may be a solid choice for those who know they will be out of the mortgage in 5 years or less. For instance, if you know that you are selling your home within 5 years and can save say $100/month in a 5 Year ARM (fixed for 5 years and no pre-payment penalty) as opposed to a 30 Year fixed rate mortgage program, this is an option worth consideration.

Negative Amortization (Teaser Rate) ARMs

Adjustable rate mortgages come in many shapes and sizes. Some are advertised with very low mortgage rates known as “Option (Power) ARM’s” or “Teaser Rates”. A "Teaser Rate" is a reduced introductory mortgage rate designed to attract borrowers to adjustable rate mortgages. This initial discounted mortgage rate can be as low as 2% or even lower. The rate adjusts to the associated current market index rate plus margin after the predetermined introductory mortgage rate time period has elapsed.

Be Careful of Low Teaser Rates

The introductory mortgage rate period is normally for a relative short period of a year or less. Monthly payments can virtually double after the introductory rate period has ended.

These loans often create "negative-amortization" (negative equity) for the homeowner because the market-rate interest (as opposed to the "discounted" introductory mortgage rate) on the loan starts to accrue from the get-go, and monthly payments aren't enough to cover it, let alone pay down any of your principal.

Rate adjustment periods are typically less than one year and commonly adjusted on a 6 month or less cycle, so your mortgage payments go on a nice roller coaster ride.

Hefty prepayment penalties are often associated with teaser-rate programs. Be very careful of refinance mortgage loan ads quoting very low mortgage rates.

Looking to Fix Your
Adjustable Rate Mortgage?

We can help you to get out of that adjustable rate mortgage and into a Low Fixed Rate home loan. When you submit a request for a Free Rate Quote with the Refinance ToolBox, you get only One Call from your assigned loan professional and avoid the hassle of the 10's to 100's of calls received from the typical "Free Mortgage Rates Quote" sites.

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Having access to the biggest refinance home loan lenders and most diverse mortgage investors allows us to pass along the mortgage rate savings to you. As an added benefit, you won't need to change your phone number and you'll be working with an experienced and honest mortgage refinance professional. If you are looking to refinance and want to see the current Best Rate and Fee Programs on the market, we encourage you to get a Fix Your Rate with us now.

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