Adjustable Rate Mortgages (ARM's)

Typical Government, Conventional and non-conventional - ARM Loans 

Great for those who plan on moving and want to rent out their home or selling their home within 2 years of the rate lock term ending.

ARM's are also used for a temporary rate reduction while the home is up for sale - thus, saving money for home owners who are already in their new home. 

Great for first time home buyers needing a break on monthly mortgage payments or those wanting to qualify for a larger house or larger home loan amount.

How ARM's are calculated:

Adjustable rate mortgage (ARM's), are mortgages with an initial interest rate lower than fixed-rate mortgages.  The most common ARM rates are temporarily fixed for a period of 1, 3, 5, 7, or as long as 10 years.

The interest rate is changed up or down by the lender at defined intervals within CAP limitations. 

The cap limits how much the loan rate can increase or decrease, for the overall life of the loan, as well as limits for each adjustment date. 

Adjustments reflect changes in a specified index that more readily reflects market rates and is calculated by adding a margin to an index rate.

i.e. 5/1 ARM at 4% with a 3/2/7 cap and a 2.75% margin

5/1
The number (5) indicates a 5 yr. Fixed rate at 4%
The number (1) indicates that the interest rate adjusts annually, after the fifth year fixed rate period.

4% and a 2.75% margin
The margin is an amount the lender adds to the index by measuring the difference between the current ARM interest rate and earnings by an index investment.

The index is a published interest rate based upon one-, three-, and five-year U.S. Treasury security yields, the monthly average interest rate on loans closed by savings and loan institutions, and the monthly average costs-of-funds incurred (COFI) by savings and loans.

i.e. the current 12 Month Treasury Average (MTA) index value is 1.25% (03/15/04) and your loan has a margin of 2.75%, your fully indexed rate is 4%.

3/2/7 cap
The first number (3) indicates a 3 percent limit on the initial interest rate at the initial adjustment date.
Example year six:
4% + (Index + Margin) can’t exceed 7%

The second number (2) indicates the interest rate can go up or down by no more than 2% at each subsequent 1 year adjustment date.
Example Yr. 7: initial adjustment +/- 2% max.

The third number (7) indicates an overall maximum interest rate is not to exceed a 7% rate increase over the initial interest rate of 4% over the life of the loan. Therefore the interest rate life cap cannot exceed 11%

Another ARM example of how a Truth in Lending Statement should spell the terms:

ARM Term: 3/27 - 6 Month LIBOR (Three year lock / Then Adjusted every Six Months)
Note: 6 month LIBOR is currently at 1.17% (03/15/04)
Margin 1.5% (Margin Adjustment Maximum after 1st adjustment)
Margins cap: 8.0% (Margin plus Interest Rate Maximum)
ARM Details: 2/1/6.5 caps (1st adjustment 2.0% Max. / 1.0% Rate Adj. Max. / 6.5% Interest Rate Max.)

VA Adjustable Rate Mortgage Loan

The Veterans Administration temporarily discontinued "VA ARM's" in 1996 and has just reinstated a new "Hybrid ARM" per the Veterans Benefits Act of 2002 authorizing VA to guarantee Hybrid Adjustable Rate Mortgages (Hybrid ARMS) during fiscal years 2004 and 2005.

VA ARM implementation is ahead of schedule and VA is authorized to guarantee a VA ARM as of October 1, 2003.

Interest rates must be fixed for a minimum of 3 years, and then adjusted annually by no more than 1% thereafter, with a maximum cap (interest rate increase) of of no more than 5% over the life of the loan.

Interest rate index will be the same as used by HUD which is the weekly average yield on U.S. Treasury securities adjusted to a constant maturity of 1 year. (This information is found in the Federal Reserve Bulletin and made available by the Federal Reserve Board in Statistical Release H.15).

Margins are dictated by the lender (Not VA).

Temporary Buydowns in connection with Hybrid ARM's is not allowed.

FHA Adjustable Rate Mortgage Loan (per HUD Guidlines)

The FHA adjustable rate mortgage loan (FHA ARM) can at anytime, be "streamline refinance" to a FHA fixed rate mortgage allowing qualification for a larger loan amount. 

FHA adjustable mortgages are designed to protect the home owner from larger payment and interest rates adjustments.  You may use this FHA loan program for 1-4 unit homes, as well as condominiums, town-homes, and PUDs.  

The yearly interest can't fluctuate more than 1% per year vs. 2% for a conventional loan but the FHA rate normally starts at a slightly higher rate than other ARM loans.  The lifetime cap of the FHA adjustable mortgage is no more than 5% over the initial start rate vs. 6% for a conventional loan.  Therefore, a FHA can take 5 years before reaching its maximum rate vs. a conventional loan can cap in only 3 years.

FHA's adjustable rate mortgage is based on the 1-Yr. T-Bill index
Calculated as follows:

Index  + Margin  = Fully Indexed Rate

(current 1 Yr. T-Bill Rate) + (percentage, usually 2.75%) = Interest Rate

Example:  Index = 4.25%  + Margin of 2.75% = Fully Indexed Rate =   7.00%

ARM Advantages

• Low mortgage start rates can reduce your initial payments
• Initial interest rate is usually less than a fully indexed fixed-rate mortgage
• Can be fixed up to 10 years
• A cap limits interest rate changes over the loan term, and at each adjustment date
• Easier to qualify for, due to lower interest rate and payment amount
• Lock in extra low rate if you plan on moving within the next 1 - 5 years 
• New creative ARM products have solutions for today's market (unlike ARM's of yesteryear)
• Lower monthly payment for up to 10 years
• Great for first time home buyers that need lower initial rates
• Qualify for larger loans due to this initially lower rate
• If interest rate declines, payment will also decline
• Caps are commonly set at 2/6 
  ( 2% max at each adjustment, 6% max over the loan life) 
• Conversion ARM allows switching to a fixed-rate
• Laws in force to limit Payment Shock
  

ARM Disadvantages

• If interest rate increases, payment will also increase
• A large increase in interest rates / payment can make the loan unaffordable
• Adjustments may be made frequently (bi-monthly, quarterly, semi-annually, yearly)
• Risky - rates haven't been this low in 40 years....bound to go back up soon.
• Caps are commonly set at 2/6 ( 2% max at each adjustment, 6% max over the loan life) 
• Some indexes fluctuate more than others
• Negative Amortization may occur if rates max out
• Conversion ARM may be costly
• Payment Shock
  

OTHER ARM FACTS:

Convertible Adjustable Loans
Convertible ARMs offer the borrower the option to convert the loan from an adjustable-rate to a fixed-rate at specified times during the term of the mortgage. 

This option is attractive to buyers wanting to take advantage of low interest rates now, and want the security of a fixed-rate loan in the future.

Payment Shock: A scenario in which monthly mortgage payments on an adjustable rate mortgage (ARM) rise so high that the borrower may not be able to afford the payments.  Consumer protection guidelines regarding extremely low initial "teaser" rates, lifetime ceilings and annual caps are designed to prevent payment shock.

Negative Amortization
This occurs when the combination of interest rates adjustments and payment caps result in a monthly payment that does not cover the interest portion of your loan.  In this case, the difference would be added back to the total amount you owed on the loan, thus making a "negative amortization" to the mortgage.

For Commercial Mortgage industry...Interst Only Mortgage Loans
see our page on CMBS (Commercial Mortgage Backed Securities)
2nd mortgages not allowed...we show a way around this


see Mezzanine Loans ...for Commercial Mortgage Loan Financing
How to get a Junior Lien (similar to second mortgage)