Note: negative amortization ARMs are discussed here.
An adjustable rate mortgage, or ARM, is a mortgage loan with an interest rate that is periodically adjusted up or down. Adjustable rate loans are based on an index, a widely published benchmark interest rate, to which a margin is added. The most common indexes are the 12-Month Treasury Average or MTA, the prime rate, the LIBOR, and the 11th District Cost of Funds. ARMs have an adjustment period; some have an interest rate adjustment every three months, others every six months or every year. At the adjustment date, the margin is added to the current value of the index in order to determine the new interest rate that the loan will have until the next adjustment date. This new rate also determines your payment until the next adjustment date.
In order to protect you from runaway interest rates, most arms have an adjustment cap and a life cap. If your adjustment cap is one point, your interest rate cannot change more than one percentage point at the adjustment period, either up or down, regardless of where the index has moved. The life cap is the maximum interest rate your loan can ever have, regardless of how high the index is at the adjustment period.
The start rate is an introductory rate offered by the lender for a period as short as one month or as long as one year. This start rate can be much lower than the interest rate determined by adding the index to the margin. Once the start rate is over and the interest rate used to determine your payment is the index plus the margin, you are paying a fully indexed rate.
Which is more important with an ARM: the margin, the start rate, or the life cap?
Let’s start with margin. The margin is the number that, when added to the index, determines the interest rate of an adjustable rate loan. For example, assume you have a 12-Month Treasury Average ARM that adjusts annually with a margin of 2.75%. Each year on the adjustment date the interest rate will be refigured, and that will be the basis for your payment for the next twelve months. On each adjustment date, the lender will add the margin of 2.75% to the index. For example, if the 12-MTA is 6.00% on your adjustment date, your interest rate for the next twelve months will be 8.75%; if it is 7.25%, your rate for the next twelve months will be 10.00%.
After your loan has become fully indexed, and within the limits of the life cap and the adjustment cap, the margin determines your interest rate for as long as you have that mortgage. For example, let’s take two borrowers whose loans have the same start rate and identical terms, with one exception—one has a margin of 2.50% and the other has a margin of 3.00%. The borrower with the 3.00% margin will be paying a half point higher interest rate for the entire period of the loan, except at the very beginning, because the start rates are the same, and when the loan is at its life cap.
Many borrowers will opt for a loan with a high margin in order to save a little on the start rate, or a half point in loan fee. This may be the right choice if you know you are only going to have that loan for a very short time, no more than three years. However, if there is a reasonable chance that you’re going to keep the loan for a while, the margin is very important.
What about the start rate?
You have seen screaming headlines that say “1.25% Start!” Start rate is pretty obvious, but deserves a note of caution. Don’t be seduced by a low start rate into a loan you may be sorry to have down the road. Consider the implications—what will you be paying two years from now, and are you comfortable with that?
Also, figure how much that low start rate may cost you in the future. With a higher start rate you might get a lower margin, which would be worth a lot more in the long run if you keep the loan for more than a couple of years. A low start rate may be worth the trade-off if it lasts for more than three months. Many negative amortization loans have a start rate that is only good for one month after which the interest rate becomes fully indexed. This means that your interest rate could go from 2.75% to, say, 6.50% after just one month. Compare that to a start rate of 5.25% on a loan that adjusts annually. The start rate is higher, but it lasts for twelve months, not just one.
On the positive side, low start rates are great if you are only going to own the property or have the loan for a relatively short time. Also, life caps are often set relative to start rates, so that a low start rate may be tied to a lower life cap.
What about the life cap?
The importance of the life cap, the maximum interest rate your loan can have, is directly proportional to how long you will have the loan. If you are only going to be in your loan for three years or less, your focus should be on a low start rate and adjustment cap. However, if you think you might keep your loan for a longer period of time, your life cap can be very important.
Remember, although it happens very infrequently, there are times when interest rates have moved steadily higher for three to five years, or even longer. Remember your risk profile—how willing you are to take a chance that your loan may go to its life cap and stay there for a while? Also, most borrowers tend not to keep an arm in periods of stable or declining interest rates. When interest rates periodically dip, many who plan to remain in their property for a considerable length of time refinance into fixed rate mortgages.
