Why would anyone consider an adjustable rate mortgage when fixed rate loans are at their lowest in over half of a century? Interest rates are even lower on ARM mortgages and for buyers who are certain that they will sell within the fixed rate term, there are significant savings to be realized depending upon current market conditions. Even so, these mortgages are not practical for everyone but for those who are absolutely sure they will own the real estate for limited period of time the savings can override the risk of a increasingly higher interest rate in the event plans change.
Today's suite of adjustable rate programs include a number of structural options but the standard market acceptable versions all follow the same basic format. The interest rate is fixed for a period of time and subsequently adjusted annually during the ensuing years. Although the primary consideration other than interest rate is the length of time to the first adjustment, the criteria effecting how the adjustments are made is also an important to understanding the impact on future mortgage payments.
Lenders are partial to ARM's because their exposure to below market interest rate mortgages rates is limited therefore they offer rates commensurate with the fixed rate term. Also because the interest rate adjusts after the initial fixed term they eliminate the accounting problem of carrying substantially below market investments on their balance sheet far into the future. The standard structural options include 1/1, 3/1, 5/1, 7/1 and 10/1 loan terms. The first number represents the fixed term and the second number represents the adjustment term thereafter. The shorter the fixed rate terms the lower the interest rate.
Indexes and margins
Annual adjustments are indexed against Wall Street published indices such as Cost of Funds Index (COFI), London Interbank Offered Rate (LIBOR), or because of its familiarity to the general public the most popular index is the 1-year constant-maturity Treasury ( CMT) securities. Financial institutions offering ARMs might select an index which reflect their cost of borrowing on the credit markets. At the end of the fixed rate term the lender will take the prescribed index price and add a margin to determine the interest rate for the next term. Margins range between 2.5% and 3.0% depending upon the specific index associated with the program and its history of volatility. The sum of the index and the margin represents the interest rate for the upcoming term as long as the annual "cap" is not exceeded.
Adjustment and lifetime rate caps
The standard adjustable rate mortgages offer the consumer some protection against escalating interest rates through limiting the size of rate increases on each adjustment period and over the life of the loan which is normally based on a thirty year payoff or amortization. The annual or per adjustment cap is normally 2%. This means that if the index plus the margin exceeds 2% of the previous interest rate, the new rate will be limited to the 2%. The lifetime cap is normally 5% to 6% above the start rate or the initial fixed rate. The potential of the interest rate eventually escalating from 5% to 10% or 11% can be a frightening thought but it would take long term extreme economic conditions for such an event to occur.
Home buyers in a stagnant or depreciating market would not normally consider an adjustable rate mortgage especially the 1, 3, or 5 year variety. Military personnel on a 3 to 5 year assignment or those planning to retire to a different location might compare the rate advantage and savings of a 7 year or 10 year ARM to the fixed rate alternative. Even if plans are delayed And the adjustments come into play for a couple of years, there is a good chance that the savings over the fixed rate mortgage during the fixed rate period of the ARM will offset higher rates due to interest adjustments.
Adjustable rate mortgages currently comprise approximately 15% of the real estate loans in America and a much higher percentage in the rest of the world. They are not the harbinger of disaster that interest only mortgages, negative amortization mortgages and balloon payment mortgages were in the past. Those loan instruments were usually not the elective of the applicant but a means for the marginally qualified to secure loan approval. When considering dangerous mortgage programs having been the only option for marginally qualified borrowers, it is not surprising that foreclosures have become rampant.
The market for ARMs is constantly in fluctuation so at any given time they may not offer enough interest rate advantage to justify the potential increase at the time of adjustment. However when the market conditions allow, the numbers on a 10/1 adjustable rate mortgage priced at.375% below a 30 year fixed rate loan are difficult to ignore particularly on high balance mortgages