Question. We are shopping around for a mortgage for our first home and are confused about the many loans that seem to be available. Interest rates are low, real estate appears to be picking up again, and the adjustable rate mortgage is of interest to us. We do not understand how that works. What exactly is an ARM, and do you have any advice on whether we should use this form of loan?
Answer. Interesting — and timely — question. For a number of years — especially since mortgage interest rates were very low — rarely did any homeowner even bother looking at creative mortgages. And there have been a lot of them. For a long time, it seems that every day, the mortgage financing industry came up with a new kind of mortgage — or at least a new twist on the old ones. Many of these mortgages have acronyms, such as as GEMs (Growing Equity Mortgages), RAMs (Reverse Annuity Mortgages), HECM (Home Equity Conversion Mortgage — aka reverse mortgage), SAMs (Shared Appreciated Mortgages), and of course ARMs (Adjustable Rate Mortgages).
Lets look at the Adjustable Rate Mortgage. This was created in the early 1980’s when lenders were hurt financially because homeowners were repaying their loans at 8, 9, or 10%, while the cost of borrowing that money was more than 15%.
Lenders made a basic decision several years ago. The shorter the term of the loan, the lower the interest rate would be. Thus, today you can still obtain a fixed-rate, thirty year mortgage, meaning that you will be guaranteed that the mortgage payment will be the same every month. But the fixed rate, thirty year mortgage — although still quite low today — carries about the highest interest rate going.
The Adjustable Rate Mortgage is guaranteed to stay on the books for thirty years, but the interest rate is adjusted periodically. There are many variations on the adjustable rate theme. There is the so-called 7-23, where the rate is fixed for the first seven years, and then adjusts thereafter for 23 more years. If the rate is adjusted for five or seven years, the initial rate will be lower than the one for a fixed rate thirty-year mortgage, but higher than an adjustable rate mortgage that is adjusted every year.
Today, the most common ARMs are the one-year, the three-year adjustable, or the 7-23. But even with these common ARMs, consumers should shop around for the best deal.
Here is what you should do:
- Determine the initial interest rate. It is defined as the rate on which your loan will be based in the initial period — whether it is 1, 3, 5, 7 or even 10 years.
- Ask if the ARM is based on a negative-amortization schedule. Although my experience is that most ARMs currently are not amortized on a negative basis, I still have seen some loans with a negative factor built in. This means that although you may be paying a lower interest rate for the first few years — let’s say two or three percent — the interest still is being charged on your loan at a higher rate — for example 4 or 5 percent.. If this is the case, the extra interest payment (the difference between what you are paying and what is being charged you), is added to your mortgage balance. Under no circumstances can I recommend the negative amortization mortgage.
- Determine what the rate adjustment will be. Find out if there is a cap on the periodic increases, and determine what index the lender uses as a base for calculating changes in the adjustable rate.
Generally, lenders use one of three indexes: (1) the weekly average yield on Treasury Bills, which is published by the Federal Reserve Board, (2) the 11th District cost of funds index — called COFI, or (3) the Libor (London Interbank Offered Rate) The lender then adds to that index number a rate adjustment (called a margin) and if the adjusted rate is higher than the old one when your adjustment period comes due, your interest will be modified accordingly for the next set of payments.
Another point to consider is whether there is a ceiling on the overall amount that your rate can increase. Lenders realize that an ARM without such a ceiling is a potential disaster for consumers. If you start with a 3 % loan, for example, and there is a 2% point cap on the yearly increases, it is conceivable that at the end of the fifth year you would be facing a mortgage rate of 13%.
Most lenders, therefore, are putting an overall ceiling on the amount that your interest rate can rise. And it is usually limited to 5- 6 percentage points. Thus, if your initial rate is 3%, the most you will ever pay would be 8 or 9%. Make sure you understand what the ceilings are, and get them in writing, before you commit yourself to an ARM.
This analysis is equally valid for the various kinds of ARMs, whether the three year, the 5-25, the 7-23 or even the 10 year ARM.
There are also serious problems with interpreting how the rate adjustment works after you get the loan. Anyone with an ARM is advised to carefully review their original loan documents, to determine whether the lender has properly and correctly assessed the new adjustable rate, when the adjustment period comes due.
And keep in mind: depending on the cap, at some point in the future, you may be required to make more monthly payments than you can afford.