Loan Types

Adjustable Rate Mortgages (ARM’s) – The Nitty Gritty Details Explain the Conundrum of Good/Bad

In recent years ARM’s have fallen out of popularity due to record low fixed rates and no teaser rates on the ARM’s that were lower than the long term fixed options. A teaser rate was usually a rate that was low enough for the first term of the mortgage to make qualifying or payments less. They were popular for people who moved often due to relocations, were at the beginnings of promising careers or others who felt they were a better option than being hemmed in for the same payment for decades.

One advantage of an ARM is that when it does adjust, if you have paid down the balance some, when the payment adjusts it will be adjusted on a lower balance than where it started. For someone who gets a large bonus every year or who really wants to pay down and pay off quickly the advantage of the lower initial rate and the recast on a lower balance after say five years can be very appealing. However, somewhere in the mixed up zone of rate drops, the start rate on the ARM’s never did and over time many investors simply removed them from their line up. Now with the advent of higher rates, we are seeing them show up on our rate sheets, though they still have yet to be very competitive. Should fixed rates move higher, we may see that change. It used to be that the disparity between the fixed rate and the start rate on a three year or five year ARM was as much as a half a percent. This would be enough to make someone qualify on a higher loan amount than with a fixed rate.

Understanding Adjustable Rate Mortgage (ARM) types is the first step to understanding if you would want one

Let’s start with some terminology first and then we will build out how all of the parts go together as there is a mechanics to these products and they vary greatly from one another based on those mechanics.

  • Start Rate – May also be known as a teaser rate that is discounted for the first term of the loan. This is the first period of the loan where the initial rate is fixed for that period before it begins to adjust. In the more traditional A paper space – basically best quality loans – are 6 months, 1 year, 3 year, 5 year, 7 year, and 10 year. In the less traditional products they can be 1 month, 3 month, 6 month and on up depending on what investors have an appetite for.
  • Index – This is what the loan is tied to for the adjustments. It will be specified in the Note as to what day in the future the current index will be used for adjusting the rate and recalculating the mortgage payment. There are many indices that a loan might be tied to. A list is posted below, though it is not exhaustive as an investor may choose to create an ARM product specific to a certain index.
  • Margin – This is a fixed number written into the Mortgage Note that is used to add to the Index during the time of adjustment. A smaller number means likely a better rate when the adjustment happens.
  • Floor – The lowest rate that a loan might be able to have and is usually expressed as a percentage below the start rate.
  • Ceiling – The highest a rate can go also usually expressed by a percentage above the start rate.
  • Adjustment Period – Phase of the loan that is adjustable and how often it is adjusted after the initial period. It may come in increments of 1 month, 3 months, 6 months or 1 year.
  • Life Cap – Amount above the start rate that is the highest it can go.
  • Annual Cap – The amount the rate can move in a given year – up or down.
  • Conversion Option – In some ARM’s there is a timeframe where a loan may be converted to a fixed rate. Usually based on a set margin (often .625) above a mortgage index – for instance the FNMA 60 day delivery rate. This would mean that the remaining timeframe at that point of the loan, and the balance are all amortized with the new rate to determine a new payment making the loan into a fixed rate loan for the remainder of the loan life.

Common Indices for Adjustable Rate Loans

A word on Indices. There are many and some are reported daily, others monthly, some every few months or annually. If you are taking an ARM, be sure to ask what the index it is tied to is. They go look at how it has behaved over the last 10 years or so. This will give you an indication of how volatile or slow moving it might be if you are planning to still own the property once the adjustment period begins. You will need to factor this in with your adjustment time frames as well.

  • Prime Rate
  • SOFR – Secured Overnight Financing Rate. Currently index used on most traditional conventional ARM’s
  • COFI – Cost of Funds Index – may be for the National index or the 11th District
  • CMT – Constant Maturity Treasury Rate
  • LIBOR – London Interbank Offered Rate – currently being phased out
  • 6 month CD rate – Weekly average of the 6 month negotiable Certificates of Deposit
  • 1-year T-Bill
  • 3-year T-Note
  • 5-year T-Note
  • NACR – National Average Contract Mortgage rate

This isn’t an exhaustive list. These are the ones that show up now or have shown up on rate sheets in the past 10-15 years. If you are considering an ARM, be sure to find out from your lender the particulars and then do an internet search for historical data on the index your loan will be tied to. Do some calculations based on the margin tied to your loan plus the index at high and low points and note how it compares to fixed rates or even your start rate.

Negative Amortizing Adjustable Rate Mortgages (ARM’s) are rare these days and are what have typically given ARM’s a bad name

There used to be a product out there called the Option ARM. It was called this because it gave you a few choices on what amount you could pay. They included a fully amortized principal and interest payment or an interest only payment or a payment that was artificially low. If you paid that last one then the difference between it and the interest owed was tacked onto the loan. You were then growing your loan balance and paying interest on your interest. You can see how this might not bode well for folks who simply paid the cheapest payment and then when the reset made them pay a fully amortized payment it was a big bite in the pocketbook.

In defense of the existence of this product, it did have a real and legitimate purpose when it was created. The problem came in where it was sold to a population that it wasn’t created for and then layered with not having to really qualify for it in verifying income. There were people purchasing very expensive homes thinking that the only payment they would ever have was that low one. Not very nice or fair. While one might argue that they should have been paying attention or that their loan officer should have been more clear, I would argue that both of these are true. Most of all lenders should have been more prudent in general. The product was made for investors who would be in and out of a project in a short time. They could qualify on and close these fast, do what they needed to do and turn the property. That negative amortization was an incentive for them to complete quickly because every payment decreased their end profits. These products, if they do exist still, are not much in the mainstream lending at the moment and may never return. There are many disclosures that come with these loans. Read them, ask questions, pay attention.

Risks, pros and cons and is an Adjustable Rate Mortgage (ARM) ever a good idea?

An adjustable rate with no negative amortization – by and large all that are offered at the time of this writing – can present advantages to a borrower. If you are taking one that has a start rate that is fixed for at least 5 years, qualification is done on the start rate. If that rate is lower than a fixed rate, this would allow a lower payment for that period of time. These are good for people that are just starting out in their careers, or who expect that they will have more income in coming years due to family or work changes. Also good if this is a stepping up house or you expect to relocate in the near future. You would also be able to put large lump sums on the balance and when the loan recasts, the payment would be based on the new loan balance.

Disadvantages if there is no negative amortization are purely subjective at this point. If the index the loan is tied to is volatile and the loan adjusts more than every 6 months or a year, this may feel like the payment roller coaster after the start rate is finished. On the flip side, there are people whose rate actually dropped after the teaser start rate was up because the markets had very much improved. Some who have taken ARM’s have done far better than those who have taken the fixed rate over the long haul. It all depends on your personal goals and situation as to whether an ARM would work in your favor or not be in your best interest. If you are considering one and unsure, seek out the counsel of those more familiar with them and share what you think your 5,10 or 20 year plan is with housing. It doesn’t hurt to consider the option. Lastly, as of this writing in Q2 of 2023, the ARM products have almost no advantage in terms of rate. They are flat with fixed and in some cases actually higher. The one exception is the longer term options are sometimes around .125-.25 on the start rate. Unless you are really tight on qualifying or monthly budget, this isn’t terribly significant.

Ask your lender the important questions if you are considering an Adjustable Rate Mortgage (ARM)

  • Ask about the availability of ARM products.
  • Ask about their terms.
  • Read the ARM pamphlet that is issued with disclosures and learn how they work and use it for a foundation for your questions.
  • Ask what the margin is.
  • What is the Index
  • Look up the Index and it’s History
  • Ask if you have options and the cost associated with taking a lower margin – this is sometimes an option
  • Take the margin and look at the history of the index and calculate what a payment would be if it were at the highest point in history and the lowest point in history
  • Find out what the life cap is and what the floor is so that you have a window of what your rate could be at the best and the worst once the teaser rate is up
  • Ask if there is a conversion option on it. When can it be converted and what are the terms? Do a calculation on what it would be if you were converting today.
  • Ask if your loan has the possibility of negatively amortizing. Unless you are getting a Reverse mortgage, which is all negative amortization, there isn’t likely any.
  • Ask how high the rate can go on the first adjustment – does it go all the way to the life cap or is there an annual cap as well
  • Do some calculations and see how it compares to fixed rate options
  • Decide what product best fits your goals
  • Seek outside counsel if you need it

ARM’s are good product, though not for everyone. In the end you’re the one that has to make that payment every month. Make sure you are comfortable with what you are agreeing to. If you are on the West Coast and have questions, tap the floating icon and reach out to me. If you’re not, find a local mortgage broker that can assist you as you figure out your direction.

Kristin M Eklund NMLS #1872091
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