With a Fixed-Rate Mortgage (FRM), one has a fixed-rate of interest, which is set for the life of the loan, like say 6%. With an Adjustable Rate Mortgage (ARM) there are two interest rate components—the index and the margin.
The MARGIN is the FIXED-COMPONENT and it remains constant for the life of the loan. The margin is the lender’s “profit margin”, if you will. No matter what happens to interest rate indexes—whether they go up or down--the lender is assured of making this percentage of profit.
Because the lender that provides ARM loans is not solely bearing the uncertainty of future events to the extent that the lender of a fixed-rate loan is, the price of the ARM loan will quite often be 0.5%-1.0% cheaper than a fixed rate product.
The “adjustable” component of an ARM is the INDEX. Indexes as they pertain to ARMs economic statistics tied to the cost of money. There are several, like the LIBOR, the MTA, the COFI, the CODI, and the CMT, to name but a few. Some indexes are stable and some are less so. But, the ones that adjust upward quickly also adjust downward as quickly. What follows are the most popular and most widely used indexes, their commonly known abbreviation, a salient characteristic and their approximate ranges over the last 10 years:
1-YEAR CONSTANT MATURITY TREASURY (CMT). 1993-2003 Range 1.25 to 7.25. Most widely used index. Roughly half of all ARMs are based on this index. Also known as the 1-Year Treasury Bill.
11TH DISTRICT COST OF FUNDS (COFI). 1993-2003 Range 2.2% to to 5.65%. The most stable index.
PRIME RATE. 1990-2004 range 10% to 4%. Many home-equity loans and lines of credit are tied to the prime rate.
LONDON INTER BANK OFFERING RATES (LIBOR). 1993-2003 range 1.22 to 7.45. The most volatile.
12-MONTH TREASURY AVERAGE (MTA). 1993-2003 Range 1.646 to 6.25. Relatively new.
When you add the Index rate and the Margin rate together, you get what is known as THE FULLY-INDEXED RATE or ACTUAL INTEREST RATE.
One benefit of an ARM loan is that it helps you qualify for a more expensive home than might otherwise have been the case because they’re typically cheaper than fixed rate products by 10 TO 20%. The reason for this is that with ARM loans the borrower shares future interest rate fluctuations with the lender. Generally speaking the shorter the adjustment term, the lower the initial rate (unless very low caps or margins apply). Because the lender bears less risk of future uncertainty lenders can price ARMs below fixed rate mortgage products wherein the lenders bear the uncertainty of interest rate fluctuations and inflation. If a fixed-rate mortgage were to have an interest rate of 7%, a comparable adjustable might have a variable rate of 6.5%, with the Index rate comprising the 4% and the Margin rate, the 2.5%. Thus, in this example, the fully-indexed rate is 6.5%.
THE ARMs of today are usually hybrids in that they have both fixed and adjustable periods. While the overall length of the most mortgages is typically 30 years, the term of the fixed-rate can vary anywhere between 6 months, a year, 2, 3, 5, 7 or as long as 10 years. After the fixed rate period expires the mortgages become adjustable for the remainder of the 30 years. Hence a 5/25 would be a fixed for 5 years and become an adjustable rate loan for 25. A 5/1 is essentially the same thing, the only difference being that the frequency of the rate adjustment is annually or 1 time per year after the first 5 years. So a couple that planned to sell their 4 bedroom home after the kids went off to college in say 5 years would probably be better served with a 5/25 or 5/1 mortgage than paying extra for a 30-year fixed-rate mortgage. Their interest rates would still be fixed but their payments would be lower than with the latter.
As referenced earlier, there are now maximum caps in place to protect borrowers from some of the excesses that they experienced when ARMs were first introduced. Among them are RATE ADJUSTMENT CAPS which LIMIT THE AMOUNT OF INTEREST, up or down, that THE RATE MAY CHANGE PER ADJUSTMENT PERIOD. THE BIGGEST MISUNDERSTANDING THAT PEOPLE HAVE ABOUT ARMs IS THAT THE RATE ADJUSTMENT CAP OR ANNUAL RATE INCREASES CONTINUE UNTIL THE LIFETIME CAP IS REACHED. THIS IS NOT SO! There are also LIFETIME CAPS which LIMIT THE AMOUNT OF INTEREST that may be charged above the initial rate OVER THE LIFE OF THE LOAN. Finally, there are payment caps which protect a borrower from having their mortgage payments rise drastically.
Like other loan instruments, ARMs are tools to be used but to utilize they properly they need to be understood fully. THEY CAN ADJUST UPWARD (which is what most people fear who recall the late 70's) but THEY CAN ALSO ADJUST DOWNWARD (which a lot of people seem to forget as we've saw between 2000 and mid 2003). Many of the things that gave them a certain notoriety in days gone by have been corrected.
While there are people who never consider having an ARM, they do, but they just don’t realize it: many staunch advocates of fixed-rates, have a 2nd mortgage in the form of a Home Equity Line of Credit (or HELOC). Ironically, these same people who decry the adjustability of ARMs fail to realize that their HELOC is more potentially volatile than a conventional ARM in that there is no fixed-rate period—it is tied to the prime rate which can change at any time. Furthermore, HELOCs are not only adjustable, but they’re also Interest Only loans with no principal reduction.
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