If you’re in an Adjustable Rate Mortgage (ARM), now’s the time to look at refinancing into a different type of loan to save money. About half of all ARMs in the U.S. are tied to the LIBOR index and according to The Economy Forecast Agency and other industry experts, there’s a strong chance that LIBOR-indexed interest rates will continue to increase up to 2% in the next 2 years.
Also, it’s important to note that the LIBOR index will be phased out by 2021. But what does this mean for you if you currently have a LIBOR ARM? (By the way, we know no one really knows what LIBOR stands for so we’ll cover that too).
Rates are on the rise.
We’ve all gotten used to the historically low interest rates that have been available over the past few years.
While a fixed-rate mortgage has the same interest rate and monthly payment over the life of the loan, a LIBOR ARM has a rate that can change (sometimes drastically) causing your monthly payment to increase or decrease. Once the rate begins to adjust, take notice! The changes to your interest rate are based on what’s going on in the market, not your personal finance situation.
As interest rates rise, there’s usually an uptick of ARMs in the mortgage world. So, let’s take a closer look to see how ARMs work with the LIBOR index.
When you choose an ARM loan, you and your lender agree on a margin. This is a percentage that’s added to the value of the index to calculate your fully-indexed rate.
Here’s an example:
Assume you have an existing 3/1 ARM based on the 1-year LIBOR index. Its rate has been fixed at 3.00% for the last 3 years, and now it’s resetting for the first time. Let’s say the 1-year LIBOR rate is 2.75%, if your margin is 3.50% your loan’s full rate is 2.75+3.50%, or 6.25%. That’s a big jump in your ongoing monthly payment! And that’s not even the whole story. Your ARM more than likely has additional parameters (caps and floors) that limit the amount your interest rate can change.
What happens if there’s no longer a LIBOR to tie to your mortgage rate?
Unfortunately, the index doesn’t go to zero and let you take advantage of the starting rate for the remaining term. Wouldn’t that be nice? And you won’t get the rate at your margin, either. Banks have been forewarned that they’ll need to be prepared to use a LIBOR replacement rate by the end of 2021. From there, a transition plan will more than likely be set in place. A lot is still unknown which can be a nerve-wracking place to be in with your mortgage.
Let’s face it, mortgage lingo usually needs some clarification. Here’s the LIBOR crash course:
A LIBOR Mortgage is an Adjustable Rate Mortgage that has the interest rate tied to a specified LIBOR index. LIBOR stands for the London InterBank Offered Rate and is an index set by a group of London-based banks and can be used in the United States for ARMs. Just think about the LIBOR index as the equivalent of the federal funds rate for the United Kingdom and Europe.
LIBOR has seven different maturities, available in five different currencies around the world, and is used as a starting point to help price other financial products and services like secured lines of equity or lines of credit, automobile loans, and even credit cards.
Caps, floors, and rates—oh my!
Caps—Limits the amount your interest rate can increase. While there are several kinds of caps, a lot of times ARMs have one cap that applies to the first adjustment, like when your start rate expires. Loans also have lifetime caps which are expressed in a specific interest rate such as 8.00%.
If we continue to use the above example, your existing 3/1 LIBOR ARM had a 3.00% start rate and a fully-indexed rate of 6.25%. If the rate increase is capped at 3.00%, your new rate cannot exceed 6.00%.
Floors—Just as caps are there to protect you, floors are put in place to protect lenders. So, if your mortgage has a floor of 3.00%, your interest rate will never drop below this number (even if the LIBOR index lowers).
What does this all mean?
Your budget is at risk with the forecast that LIBOR-indexed interest rates will increase another 2% in the next 2 years, and the anticipated elimination of LIBOR entirely in the next 5 years. If you’re in an Adjustable Rate Mortgage, now’s the time to look at refinancing before this rate goes up or completely goes away to help you avoid blowing your budget.
We are always here for you to clarify the differences across all available loan types. Reach out to a Churchill Home Loan Specialist today to get your free mortgage analysis and find out how you can avoid increasing your payments.