How Adjustable Rate Mortgages (ARM) Work

Adjustable rate mortgages are home loans structured in a way that allows lenders to change interest rates to a higher or lower percentage.

The variables that determine how much to change and which direction to change depends on the terms of the contract.

Many countries give lenders the discretion to make interest rate changes as and when they deem it necessary.

A mortgage that is pegged to a bank’s internal board rate is one such example of discretionary ARMs where the lender will have the power to increase or decrease interest as they see fit.

However, when it comes to adjustable rate mortgages in the US, rate movements follow the movements of index rates that a loan is pegged against. Effectively making them mechanical.

Because lenders have little control over which way these index rates will move, consumers will be less likely to feel being played by lenders.

In a way, indexed ARMs are more transparent as lenders don’t have absolute control over rate increases and decreases. How much interest a loan will costs will depend on market movements that influence the indexes.

However, there are caveats as the LIBOR scandal has shown.

Reasons to choose an ARM

When a borrower is said to choose an ARM, it almost always exclusively refers to choosing it over a fixed rates mortgage (FRM) as they are the 2 main categories of mortgages lenders offer to consumers.

There are countless reasons why people choose ARMs. But the main and common ones are:

  • The loans they desire are only available in ARMs
  • Low interest rates on initial years fit nicely into short investment time lines
  • Expecting interest rates to drop in general, pulling down mortgage rates with it

In times of depressing interest rates, adjustable rate loans will look more attractive. While in times of interest rate hikes, fixed rate loans will be enable a borrower to lock down low rates.

Determining Interest rates on ARMs

ARMs are also referred to as a form of hybrid loan as they usually commence with an initial period of fixed interest rates which coincide with a “lock-in” period whereby borrowers will be charged a prepayment penalty during this period.

A 5/1 ARM for example, would mean that the initial period is 5 years while it adjusts on a 1-yearly basis.

At the end of this initial period, the mechanics of ARM kicks in.

Sometimes, interest rates during this initial phase will already be pegged to index rates.

Also known as floating rates because the ultimate interest that a borrower pays will be moving with the indices, rate on the ARM will depend on the index that it is pegged to plus a margin (or spread), then rounded to the nearest 1/8%.

For example, 3-month LIBOR + 1%. In this case, if 3-month LIBOR is 2%, the total interest, which is the fully indexed rate, the borrower will pay is 2% + 1% = 3%.

This new rate will be subject to adjustment caps and rate ceilings.

At this point, since we are talking about LIBOR, it is important to know what is a refresh rate.

There are various types of LIBOR separated by time frames. For example, you can find it in 1-month, 3-month, 6-month, 1-year, etc. It is common practice for lenders to originate mortgages with interest rates that refresh according to the time frame (maturity) of the index rates.

For example, if you are on a 3-month LIBOR, the index for 3-month LIBOR will be used for calculating the mortgage interest (plus the spread) for the next 3 months. It will only refresh to a newer 3-month LIBOR 3 months later.

A 6-month LIBOR will refresh bi-annually. And so on.

The refresh rate can sometimes be as long as 5 years. And as short as 1 month.

However, a majority of loans are adjustable annually.

This adjustment interval can sometimes be a critical element in deciding which and what type of loans to take up.

When floating interest rates on an ARM are refreshed, it might be subject to certain terms and conditions.

An example is the presence of a rate adjustment cap might limit any increase to a maximum of 2%. Thus, even if an index rate goes up by 3%, the maximum upward adjustment that the mortgage rate go is an increase by 2% according to it’s terms.

An interest rate cap might also set a ceiling of mortgage rates to 7.5% for example. In this case, no matter how high indices rise, the maximum interest the borrower will pay on the mortgage is 7.5%.

In view of the certainty that interest rates will change, quoted interest rates on mortgages is not a very good base for a borrower to calculate interest expenses over the life of the loan. Yet it is the best he can hope for.

It can at least be useful in determining the initial payment.

Common indices used in mortgages include:

  • Certificate of Deposit (CD Index)
  • Cost of Funds Index (COFI)
  • London Interbank Offered Rates (LIBOR)
  • Treasury Bills Index
  • Prime rate
  • etc

The choice that consumers decide will usually be come down to 3 factors of volatility, availability, and level.

If you are a meticulous borrower, do conduct research into the historical values of these indices.

How ARM monthly payment is determined

There are 2 main categories of how monthly payments are calculated:

  1. Fully amortizing ARMs
  2. Negative amortization ARMs

Whenever there is an interest rates change, fully amortizing ARMs monthly payments are adjusted to be fully amortizing to pay off the loan over the remaining tenor assuming the rate remains unchanged throughout the period.

On the other hand, negative amortization ARMs can work out payments that don’t fully cover the interest owing. Effectively adding the balance into the total amount still owing.

This repayment phenomena can occur when:

  • The interest rate used to calculate the payment is lower than the actual interest rate
  • The payment adjust yearly but the rate adjust monthly
  • A huge rate change that is stopped on it’s tracks by a payment adjustment cap
  • etc

However, even though the weird existence of negative amortization is a reality, they are only temporary as all mortgages are designed to fully amortize over their set term.

This means that at some point, monthly payments will be adjusted to be fully amortizing.

Lenders ensure this by inserting contract provisions into the agreement. This could be in the form of a recast clause or a negative amortization cap.

Low initial rates mean easier qualification

Many people don’t quite understand the logic behind why it could be easier to qualify for an adjustable rate mortgage than a fixed rate mortgage.

After all, aren’t FRMs supposed to be less risky and therefore easier to get approved for?

The reason behind this is that when conducting underwriting and credit analysis to assess a borrower when one applies for a mortgage, the interest rate of the loan has to be used to conduct stress tests on the borrower’s income.

Only the initial interest rates of the loan is used to calculate the monthly for the whole term of the loan. This is even when it is known that interest rates will rise after the initial period of low teaser rates.

This is why it can seem that a borrower will be able to obtain a higher LTV and better handle an ARM instead of a FRM that will have a much higher initial interest rate.

From an investment perspective, the short term low interest rates can play nicely into the strategy of an investor with a shorter time span.

For example, if an ARM has a very attractive teaser rate across the first 3 years of the loan, then it suits an investor with a 3-year exit strategy perfectly. He would be out of the market by the end of the years of teaser rates and long before rate hikes kick in.

A FRM can present problems for a short term investor firstly because of higher rates which is a feature of fixed rate loan. Secondly it might come with commitment periods that trigger penalties when loans are redeemed within that period.

ARMs for long term investors and homeowners

Saying that, the game is not over for a long term investor if he has chosen to take up an adjustable rate mortgage. He can still enjoy the teaser rates during the initial years and then find sources to refinance the loan when interest rates rise. Ideally with a new loan with attractive teaser rates as well.

The success of refinancing however, is not guaranteed as credit criteria might become more stringent in future or the borrower’s personal income might have fallen drastically.

When the thought of refinancing or selling the house is not in the short term plans of the borrower signing up for ARMs is like placing a bet on interest rates remaining flat or falling further.

This is because a fixed rate mortgage can guarantee a fixed stable interest over the long term.

Why would you not choose that unless you have a hunch that interest rates in general will continue to be depressed in future?

If interest rates do fall or tumble, then the interest cost of an ARM would be markedly lower compared to a FRM.

That’s the investor’s reward for taking a punt on a low interest business environment.

Convertible ARMs

As consumers become more informed about the pros and cons of ARMs and FRMs, lenders have come up with hybrid mortgages that enable customer to enjoy the best of both worlds.

For example, there are now ARMs being offered that have an option to convert the ARM into a FRM at some point in future.

The conversion option would of course come with an expiry date to exercise it.

Market conditions that exist when teaser rates expire could make this conversion invaluable.

It would be akin to refinancing without incurring all the administrative and legal expenses that comes with closing it.

However, the interest of the FRM will depend on the available FRMs the lender will be offering at that point in time. A borrower cannot lock down a low rate for future use.

This also means that should interest rates rise, it will make absolutely no sense to exercise the option to convert as the existing mortgage the borrower is on could very possibly be better that the mortgages that are available in the market at that point in time.

Finally, when comparing ARMs and FRMs, there is no definitive answer to which type of loan is better than the other.

It all depends on the situation, the market, and the personal preferences of the borrower.