If Stairway to Heaven is the most overplayed song, then the 30-year fixed mortgage has got to be the most overplayed loan option. And like the iconic tune, the 30-year fixed is really great. I mean for most borrowers, it’s the clear way to go. No rate changes, 360 equal payments and if you don’t refinance, sell the house or kick the bucket first, the loan is fully paid off 30 years down the road. But even if the 30-year fixed is a great and popular option, is it the best option for everyone? We’re seeing that more and more homeowners are opting for ARM loans these days but with that choice comes additional complexity and terminology to understand, so let’s roll up our sleeves, bear our guns and get our arms around ARMs.
Slingin’ ARM Lingo
When one starts examining an adjustable rate mortgage, things can get interesting, fast. Why? Because unlike the straightforward concept of a fixed rate loan, ARMs have several features that govern how they will work over the course of their term. We’re going to cover each below. But first…
The programs we’re going to cover on the ARM side are technically “hybrid” loans, and that’s all we really tend to see here in 2019. True, adjustable rate mortgage that do not have an initial fixed rate period are rarities in the residential home loan environment. So even though we call any loan that has adjusting features an “ARM” most of the mortgages you’ll encounter will have at least three years fixed at the start. And it is by this very start rate that an ARM loan will get its name; 3/1, 5/1, 7/1 or 10/1, that first digit designates the amount of fixed years at the beginning of the term. True, most of these loans will have a total 30-year term, but once beyond the fixed rate period, the loan begins adjusting and remains that way for the remainder of (what is usually, but not always) the 30-year total term.
Index and Margin
So what happens once a hybrid ARM converts to adjustable? You’ll recall that in our examples above (3/1, 5/1, etc.), we learned that the first number defines the fixed years at the start, but what about the “1”? What does that mean? It means that once the loan begins adjusting, it will do so once per year. Years ago, you’d even see a 5/6 ARM, for example. In that case, 5 years fixed to start and then adjustments every six months. But back to our fixed-to-ARM conversion. Let’s say we have a 7/1 ARM. We’ve held the loan for all seven years to start and now we are beginning the adjustable rate period. The loan servicer will take a margin, which is fixed and dictated by the loan’s Note, and add it to an index, which is adjustable and named at the start. A common margin might be 2.5% and a common index might be the 1-year LIBOR. So again, seven years in the future, the servicer will combine 2.5% with whatever the 1-year LIBOR is at that time and that will provide the fully-indexed rate (FIR). Were it not for ARM caps, this would be the borrower’s rate for the next year. But, not so fast, ARM loans are governed by limits on how much they can adjust and that’s our segue way to caps.
Hybrid ARM loans will usually have three caps; a first adjustment cap, a periodic cap and a lifetime cap. The caps are relative to the start rate. Caps will read something like this: 5/2/5. This would mean the loan has an initial 5% cap above the start rate, a 2% cap from year to year once adjusting and a lifetime cap of 5% over the start rate. A “floor” rate may also be designated and this would be the lowest the rate could go at any time during the term, despite what the index might otherwise dictate. Let’s jump into some examples:
Case 1: 7/1 ARM, 5/2/5, Margin of 2.5%, Index is 1-Year LIBOR, Floor is margin, start rate is 3.500%
This loan will have a 3.5% interest rate for 84 payments. After that time, let’s say the index is 6%. The servicer goes to adjust the loan and the FIR is now 8.5% (index of 6% + margin of 2.5%). The first adjustment cap of 5% over start rate has not been exceed and the borrower’s rate can jump to 8.5%.
Case 2: 7/1 ARM, 5/2/5, Margin of 2.5%, Index is 1-Year LIBOR, Floor is margin, start rate is 3.500%
Our borrower continues to hold the loan in Case 1. At the beginning of year nine, the index is now down to 2.5%. The FIR is now 5%, however the 2% periodic cap would limit the rate reduction to 6.5%. If the index remains the same, the borrower’s rate could then drop to 5% in year 10.
Case 3: 10/1 ARM, 2/2/6, Margin of 2.5%, Index is 1-Year LIBOR, Floor is margin, start rate is 4.000%
The borrower has 120 payments at 4.000%. During this time, the 1-Year LIBOR goes to 18% and stays there for 20 years. In year 11, the first adjustment cap would limit the borrower’s rate increase to 6% and it would stay there for a year. In year 12, the periodic cap would limit the next change also to 2%, so the borrower would pay 8% that year. Finally, in year 13, the life cap would limit the FIR to 10% and keep it no higher than that for the remainder of the loan’s full, 30-year term.
ARM vs. Fixed
So which is best? As you might suspect, this is a highly individual choice that involves the universal risk/reward concept. If you plan to stay in the home for less than 10 years, for example, and if you can tolerate the possibility that your rate and payment could increase if you overstay your expectations, a 10/1 ARM could be a great fit for your needs. Every month you pay at the rate that is less than what you would have obtained by taking a 30-year fixed, you save. This is how most borrowers will assess the choice. But there is another camp too, and I have visited it many times over the course of my career in advising those looking to buy or refi. There are simply some who will not sleep well at night thinking that their mortgage payment might ever go up. For this group, it’s best the math gets set aside and a fixed rate option moves to the front. Like other financial risks in life, one can pay for insurance, and a fixed rate loan provides that in the mortgage lending world.
If it ain’t broken,
Robert J. Spinosa
Vice President of Mortgage Lending
Marin Office: 324 Sir Francis Drake Blvd., San Anselmo, CA 94960
Berkeley Office: 1400 Shattuck Ave., Suite 1, Berkeley, CA 94709
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