ARMs

In our last blog we covered the basics of the new Adjustable Rate Mortgage(ARM) loans being offered and for whom they might be a good option.  In this blog we will cover some specific details on how these types of loans work.

An ARM loan is a 30 year amortizing loan, just like a regular 30 year mortgage.  The difference is that after an initial fixed rate and payment period, the rate and payment will change periodically based on pre-defined rules and limits.

The initial rate and payment for the fixed period (usually the first 5, 7, or 10 years) is straightforward.  Understanding how your rate and payment will change after the fixed period is the key to understanding your ARM Loan.  Every industry has its own jargon.  Ours is no different.  When you are looking at ARM Loans you will see them named a certain way.  Examples:

• 10/6 ARM
• 7/6 ARM
• 5/6 ARM

These loans all amortize over 30 years.  So for a 7/6 ARM for example the initial low rate and payment you are offered will be fixed for the first 7 YEARS of the loan.  The first adjustment to rate and payment will occur at 7 years. The rate and payment will change subsequently every 6 months thereafter, hence 7/6.

There are some key terms related to ARMs you will need to know:

Index:  This is an interest rate that changes daily and is published for everyone to see online and in major publications like the Wall Street Journal.

Margin:  This is a rate that is fixed forever by your lender at the time you initially get your loan.  Your loan officer can let you know what the Margin will be on your ARM Loan.

Fully Indexed Rate:  This rate is simply the index rate plus the margin rate and is calculated everytime your loan rate is due to be adjusted.

Every time the loan rate and payment are due to adjust, the lender will check the index rate online 30 days before your first adjusted payment is due and adjust your rate by adding the current index rate value to your margin rate value.  This will be your new Fully Indexed Rate and will used to calculate your new payment.

Example:  On a 5/6 ARM at the end of 5 years, your loan is due for its first adjustment.  The lender looks online and sees the index value is 1.55%.  The margin on your loan is 2.75%.  The lender sets your new loan rate to 4.30%.  The following month your new payment will be required based on that new rate of 4.30% and the number of months remaining on your loan.

A final wrinkle to all this is the term CAPS.  These are put into place to put limits on the adjustments to protect borrowers in case the market goes really crazy.  For the new agency ARMs, for example, if the CAPS are 2/1/5; the “2” means that when the lender adds the current Index rate value to the margin rate value to calculate the new fully indexed rate for your FIRST adjustment, the new rate cannot be more than 2.00% above the initial rate no matter what the lender calculates as the fully indexed rate.  The “1” means that for each subsequent adjustment after the first one, the new rate cannot be more than 1% over the previous rate.  And the “5” means that at no time can the rate ever exceed 5.00% over your initial rate.

For example, on the current batch of ARMS, we are offering 5/6 ARMS with a start rate of around 2.00% these days.  That rate and payment won’t change for 5 years.  At the end of 5 years, if the index value is 1.55% and it is added to the margin of 2.75%, the new fully indexed rate is 4.30%.  However, since there is a 2% CAP on the FIRST adjustment, your new rate would not be 4.30% it would be changed to only 4.00% because of the 2% “initial adjustment CAP”.  (I wish that was less of a mouthful to explain.)

Make sure you understand these 4 key terms Index, Margin, Fully Indexed Rate, CAPS.

So let’s look specifically now at the current agency ARMS and see how they are structured.  Do you understand these terms so you can talk the jargon with your loan officer?:

CURRENT OFFERINGS

• ARMS Offered: 5/6, 7/6 & 10/6 ARMs
• Margin: 2.750% (will never change)
• Index: Name: “1 Mo. SOFR” (so you can check its value anytime by yourself online)
• Index current value: 0.05%  (pretty low right now!)
• CAPS on the 5/6 ARM: 2/1/5
• CAPS on the 7/6 and 10/6 ARMs: 5/1/5

So now you are an ARM loan pro.  Congratulations!  If you ever need to check the current value of SOFR, or if you really want to nerd out on what the SOFR index actually is you can check the details here — Secured Overnight Financing Rate Data. Just scroll down to get the current and historical values.

Happy ARM hunting.

• By Rob Musseman
• August 1, 2021

Earlier in my career Adjustable Rate Mortgages (ARMs) were very popular products because lenders offered borrowers an extremely low initial fixed rate and payment in return for the option to adjust the rate and payment periodically within limits after the initial fixed period ended.

For the past few years however, the difference between rates for a standard 30 year fixed and rates for 30 year loans with rate/payment fixed for only the first 5 ,7, or 10 years have not been much different.  As a borrower in recent times, there has been really no reason to expose yourself to any risk of a rate change 5, 7, or 10 years into your 30 year mortgage if you are not getting rewarded with a better rate/payment for the initial fixed period.  Consequently, ARMS have not been popular with borrowers for the past few years.

Why did the deals go away?  Traditionally, lenders get nervous lending out money at low fixed rates guaranteed for 30 years if they think there is a good possibility they could get a higher rate for their money in 2 -7 years.  This lender fear correlates with strong deals on ARM loans for us borrowers.  Over the past few years however, rates have been dropping and economic growth has been relatively slow.  Lenders have expressed little to no fear of rates rising anytime in the near or intermediate term, so have not offered ARMS with great low start rates in return for the right to tweak the rate after 5, 7, or 10 years if rates were to rise.

So are the deals back?  With rates now at rock bottom, (ie almost nowhere to go but same or up), and with the substantial economic stimulus being pumped into the economy by both the Fed and the Treasury, talk of inflation is once again in the air, and lenders are getting a little jittery again as we are in uncharted territory.

In short, the deals appear to be back.  We are offering some pretty hot rates if you are willing to allow adjustments to your rate/payment after the first 5 or 7 years of your 30 year loan.  So what should you do?  Well, if you are not overly concerned that rates will go much higher anytime over the next 5-15 years and/or if you believe there is a good chance you will either move, or pay down your loan a lot over the next 5-9 years, you may be poised to take advantage of some of the really low initial rates on ARMs these days.

One catch to note, if you are trying to buy your dream home and are finding it’s just a little out of reach payment wise, the lower payment ARM might not be the solution.  The government wants to make sure people qualify for 30 year fixed rate loans at the 30 year fixed rates before they will allow you to consider an ARM.  So think of the ARM as a low payment/low rate option for folks who can already qualify for a 30 year fixed.

In summary, ARMS are once again a great way to save money over the next 5-10 years on your mortgage, just make sure you understand the risk reward tradeoffs and it works for you.

In my next blog post I will discuss the mechanics of these new agency ARM products, ie how the rates adjust, when they adjust, the limits of the adjustments, etc.  I look forward to your comments and questions.

• By Rob Musseman
• July 28, 2021