Adjustable Rate Mortgage Basics
An Adjustable Rate Mortgage (ARM) is normally a 30 year fully amortizing loan that has an interest rate that will adjust once an initial fixed rate period has expired. ARM have a “fully indexed rate” that is determined by a margin and an index. An ARM also has caps that limit the amount an interest rate can change after the initial fixed period has expired as well as a floor that limits the lowest rate that can be achieved after the initial fixed period.
Let’s take an example: a 5/1 ARM with a start rate of 3.5%, caps of 5/2/5, a margin of 2.75%, and an index tied to the 1 year US Treasury, and a floor of 4.5%. For the first 5 years (i.e. 60 months) the payments will be based off the 3.5% interest rate and then after 5 years the rate will change every year based off the index.
For this 5/1 ARM example the “5” indicates the number of years the rate will be fixed before its first adjustment. The second number represents how often the rate will adjust after the first change; in other words, the “1” means it will change every 1 year after the first adjustment.
Fully Indexed Rate / Index
The Fully Indexed Rate (FIR) is the margin plus the index. The margin is determined by the investor and will not change. (This is typically around 2.75%). The index is what changes and will determine the future interest charged. The two most commonly used indexes are the LIBOR and the 1 Year US Treasury* and the LIBOR. For our example we are using the 1 Year UST.
Fully Indexed Rate (FIR)
On month 61 the rate will adjust to the fully indexed rate and that will be determined by what the 1 year US Treasury index will be at that time. Let’s assume the US Treasury will be 2.0% for the first adjustment. This means the new payment will be 4.75% (the 2.75% margin plus the 2.0% UST). Let’s then assume that 12 months later the UST is 2.5%. This means that the rate for that year will be 5.25% (2.75% margin + 2.5% UST).
The 5/2/5 caps limit the amount of change in rate during adjustment periods. In this example the first “5” represents the maximum adjustment in interest rate for the first adjustment (i.e. during month 61), the “2” is the cap on future adjustments, and the last number, the other “5” is the maximum amount of change ever allowed.
Let’s now run some numbers for a very extreme example where all the caps would come into play.
For our example, let’s assume 5 years have passed and the 1 Year UST is 10% during the first adjustment period (i.e. month 61). The Fully Indexed Rate should be 12.75% (2.75% margin + 10% UST); however, the first “5” means that the maximum rate can only be 8.5% (the initial 3.5% rate + 5% = 8.5%) and not the 12.75%.
Let’s now assume another year has passed and we’re in month 72 of the loan (i.e. 6 years have passed). The “2” in the 5/2/5 is maximum adjustment for every subsequent change after the first adjustment period, meaning year 6, year 7, year 8, and so on can only adjust up or down by 2%. Let’s assume the UST went from the aforementioned 10% down to 3% during that 12 months which should make the Fully Indexed Rate 5.75% (2.75% margin + 3% UST). The reality is that the Fully Indexed Rate would only be 6.5% because the “2%” cap limited the change from the aforementioned 8.5% down to 6.5% (8.5% – 2% = 6.5%). Then let’s say the following year the 1 UST went 9%, the fully indexed rate won’t be 11.75% (2.75% margin + 9% UST), instead the fully indexed rate will be back to 8.5% since the 2% cap limited the change.
And the last number of 5/2/5, the second “5” in this example, is the lifetime cap that the interest rate can change. Meaning that over the course of the loan the rate cannot exceed 8.5% at any time (3.5% initial rate + 5% cap).
The Floor Rate, which is 4.5% in this example, limits the lowest that the rate can go after the first adjustment. Meaning that if the index is 1% and the Fully Index Rates should be 3.75% (2.75% margin + 1% UST); however, the Fully Indexed Rate will be 4.5% since the floor won’t let the rate go below that amount.