By Douglas Katz – 06/23/2022
So now that I have your attention, no we are no talking about your appendages. We are talking about adjustable rate mortgage (ARMs) and their use is on the rise again. CNBC just published an article titled Demand for adjustable-rate mortgages surges, as interest rates make biggest jump in 13 years and that increase is a significant one. I can tell you by experience that applicants in the past would cringe at the mention of an ARM before now and many are asking for information on them as they manage their expectations and options for the purchase of a home. So what about the ARM? Is it good or bad? The answer is neither. They are a tool meant for certain scenarios and if you understand them, they can be a useful one.
First lets address what an ARM actually is. ARM stands for Adjustable Rate Mortgage, which essentially means that the rate is not fixed for the life of the loan. ARMSs will have a fixed period such as 3-year, 5-year, 7-year or 10-year after which the rate CAN adjust UPWARD or DOWNWARD based on the market. That is it, from a general understanding, that is all that defines an ARM. The devil as they say is in the details, so if you are looking at ARMs as an option, the important part is to understand the exact components of the specific ARM program that you are considering because they vary from lender to lender. Luckily, the terminology for all ARMs is the same so comparison is relatively simple.
Here is a quick rundown of the terms:
- Fixed Period – The period of time in which your loan would be fixed.
- Indexed Rate – The rate that you would pay IF your loan adjusts and generally is looked at from the ceiling that it can hit due to market conditions. It will be the sum of the Index to which the loan is tied plus a pre-defined margin. Note that this will be determined at the end of the year that you are currently in, i.e. first adjustment will be calculated at the end of year 5.
- Index – The market index, i.e. 1 -Year Treasury (T-Bill) or 11th District Cost of Funds Index (COFI), that will be the basis of your indexed rate.
- Margin – The percentage added to the Index to establish your indexed rate. Typically 2.5% or 2.25%, but it can vary from lender to lender.
- Caps – The limit in the overall and individual adjustments used to establish a ceiling and sometimes floor for adjustments. These are broken down into three categories – initial, subsequent and life of loan. When reviewing a loan terms, you will see these represented as individually, i.e. 5,2,5.
- Initial – The max a loan can adjust on the first adjustment coming out of the fixed period. Typically these range from 2% to 5%. In the example above a loan would have a 5% initial maximum adjustment.
- Subsequent – The amount that a loan can adjust on an annual basis after the first adjustment. In the example above, the loan could adjust 2% annually based on market conditions NOT TO EXCEED THE LIFE OF LOAN MAXIMUM.
- Life of Loan – The most that a loan can adjust.
Because this may be a bit confusing, let me give you an example:
Assume that you are considering a 5-year adjustable rate mortgage for the purchase of a home and the initial rate is 5%. The loan is ties to the T-Bill and the margin is 2.25%. The caps are 5,2,5. Here is how to evaluate it.
- EXAMPLE 1 – Your index rate will be 1-Year T-Bill at end of year 5 plus 2.25%.
- Currently the 1-Year T-Bill 2.78%, so if your loan was to adjust today, your rate would be 5.03%.
- Some forecasts are predicting the 1-Year T-Bill to be ~5.45% by 2027, so you could expect the indexed rate to be 7.7%.
- Your initial cap is 5% for the first period, so 7.7% would be your new rate when the loan adjusts.
- Because this also matched the overall life of loan cap, this would be your rate until market condition change in you favor at which point it could go down to match the new indexed rate.
- EXAMPLE 2 – Your index rate will be 1-Year T-Bill at end of year 5 plus 2.25%.
- Assume the forecast for the 1-Year T-Bill 8%, which is unlikely but helps for overall understanding of the mechanics of an ARM. Based on this your indexed rate would be calculated at 10.25%, BUT due to an initial and overall cap of 5%, your new loan rate would be 10%.
- Since this is the max rate cap is 10%, this would be your rate until 1 -Year T-Bill decreases.
So as you can see, there is a high degree of variability in the potential outcomes after the fixed period. This is why these program concern many people and they avoid them, but they may be missing out on a good opportunity to save some money. In situations where you expect to sell the fixed period or even into the first adjustment, this is a good program because you may never see the adjustment or you could minimize its impact. If you are planning to refinance to pull out equity, a fixed rate for the life of the loan does not matter. Again, you will never see the adjustment period. Finally, if you need to temporarily manage cash flow and expect to have more income later on, this is again a good program. It is worse to rack up higher cost debt or not have reserves than to risk an adjustment. So, you can see that this is actually a very useful tool, but you need to also heed some caveats.
If your intent is to qualify for more than you can afford, this is the wrong program. While the indexed rate may stay the same or drop, if it does not, you could see a huge increase in your payment that can spell disaster. Many in the 2008 crisis saw this issue and, in fact, the misuse of this program was one of the contributing factors to the meltdown. Fortunately, many of the underwriting guidelines have been managed to account for these situations and loan approval is now based on an indexed rate as opposed to the initial rate. That said, underwriting guidelines also allow for over 40% debt-service ratio using GROSS INCOME. You may qualify at that rate, but you need to see what impact that you will have on your personal budget, which you better have before buying or refinancing a home.
As always, this is a time to lean on your subject matter experts and the professionals that support you. Talk to your financial advisor and CPA to see to see how an ARM or ANY MORTGAGE impacts your financial plans and goals, especially in times of change and/or volatility both externally, i.e. the financial markets, and internally, i.e. marriage, divorce or when you add someone to your household. Your lender should also be a main resource. They can work closely with you to see if an adjustable rate mortgage makes sense for you. They key is not to fear ARMs or any program, but rather to be informed and to make the best decision.