Adjustable Rate Mortgages: What You Need to Know

By Donna Reynolds Boyer

With so many options available, finding the right mortgage can be challenging. Many real estate advertisements tease prospective buyers with the promise of low interest rates and easy payments. But the fine print on these advertisements usually reveals that the promised rate is not fixed, and this is, in fact, an adjustable rate mortgage (ARM). Before considering an ARM, it is important to understand the implications and parameters of this type of loan.

What is an ARM?
As opposed to a fixed rate mortgage, where the interest is calculated at a set percentage and carries forward through the life of the loan, the interest on an ARM is recalculated at pre-determined intervals and can increase, decrease, or remain the same. Initially, the interest rate on an ARM is generally lower that that of a fixed rate mortgage. These starting rates are called "teaser rates," and can be from one to four percentage points lower than those being offered on conventional mortgages. Because many financial institutions will determine a buyer's qualifications to repay a loan based on their income at the time of the loan, these lower rates often help to qualify buyers who may not be approved for a loan with higher payments. A lower interest rate means a lower monthly payment, making the loan more affordable and the buyer more attractive to the lending institution.

How are ARM Interest Rates Calculated?
ARMs are tied to an index rate, which in turn, generally reflect the ebb and flow of interest rates. Many lenders tie these indexes to U.S. Treasury securities, but they can also reflect national, regional, or local trends. The lender must disclose the index that is being used to calculate the interest.

To determine the interest rate on an ARM, lenders are allowed to add a few percentage points to the index rate. This is called the margin, and can vary between lenders. The margin is also fixed over the life of the loan. The actual interest rate is calculated by adding the index rate and the margin. For example, if the index rate is 7 percent and the margin is 2 percent, the interest rate will be 9 percent. A difference in one or two percentage points can have a significant impact on the total monthly payment.

The interest rate on an ARM is recalculated at specific intervals over the course of the loan. This is called the adjustment schedule and can range from one to five years. These intervals will not change over the course of the loan, and the borrower will be notified several months prior to the end of the interval as to what the new rate and resulting payment will be.

What is an Interest Rate Cap?
An interest rate cap will limit the amount that the lender can raise the interest on the loan. There are two types of interest rate caps - a periodic cap and an overall cap. The periodic cap will limit what the interest rate can be between adjustment intervals and is spelled out specifically in the contract. For example, the contract could specify that if interest rates increase by five percent, the interest could only be three percent. This protects the borrower from facing a steep increase in the mortgage payment and also protects the lender from potential default on the loan.

An overall cap or lifetime cap is currently required to be included on all new ARMs. This limits the amount that the interest rate can increase over the starting rate and is fixed for the life of the loan.

What is a Payment Cap?
A payment cap specifies the percentage that the actual payment can increase over that from the previous adjustment period. This does not limit the interest rate, however, and while this protects the borrower from sharp increases in the monthly payment, it can also result in a situation where the payment does not cover the principal and interest. This situation is called negative amortization. If this condition prevails over an extended period of time, the borrower will face a shortfall in interest payments. This amount will be added to the total amount due, and interest will essentially be charged on interest. Ultimately, the borrower can owe the lending institution more than the initial amount of the loan and will either be forced to "catch up" on payments at some point or repay this amount when the house is sold.

In some cases, the mortgage may protect the buyer with a limit on negative amortization, but this would not be protected by the payment cap.

What is Prepayment?
Prepayment is a term used to describe a situation where a borrower wishes to pay off the full amount of the mortgage before the term of the loan expires. Some lending institutions allow a borrower to do this without penalty, while others charge penalties and fees. The stipulations for prepayment should be clearly indicated in the contract at the time of the loan origination.

What is Conversion?
Conversion allows the borrower to essentially exchange the ARM for a fixed rate mortgage. Normally, there are fees involved in doing a conversion, but many borrowers find that, over time, their financial circumstances improve, and they can qualify for a lower rate fixed mortgage. As with prepayment, the lending institutions terms regarding conversion should be specified in the contract.

What is a Mortgage Transfer?
A mortgage transfer allows a borrower to assign the mortgage to a new buyer with the same base rate, adjustment schedule, caps, and other features. A borrower should inquire if this is something that is allowable under the terms of the contract.

Can an ARM Term be Reduced by Making Extra or Higher Payments?
With a fixed rate mortgage, it is possible to reduce the term of the loan by making higher monthly payments than those specified in the loan agreement. The extra amount is deducted from the principal, thus reducing the amount of interest and allowing the borrower to pay off the loan quicker.

With an ARM, however, the mortgage payment is recalculated at each interval based on the loan being paid off over the period that remains in the original contract. If the borrower has been making higher payments, the amount of those payments is deducted from the amount of principal that is owed, but the total amount is still divided out over the months remaining on the contract. The monthly payments may decrease, but the term remains fixed.

Is an ARM the Right Choice?
ARMs offer borrowers the benefit of lower payments initially, and can make the difference in an individual being approved for a mortgage. But there are some important factors that should be considered before making a decision to go with an ARM over a conventional fixed rate mortgage.

• Will the prospective borrower's future income be adequate to handle higher mortgage payments should the interest rate increase significantly? An ARM may be a good choice for a younger, first-time home buyer who is just starting his or her career. For a person nearing retirement, however, an ARM may not be the best choice in that the person's income may be reduced significantly before the term of the mortgage expires.
• Are there future expenses that will significantly affect the prospective borrower's income and make higher payments difficult to handle? These expenses can include college tuition, weddings, car loans, weddings, and caring for elderly parents.
• How long is the prospective borrower planning on staying in this home? If it is a short term situation, an ARM may be the better choice as the change in interest rates will not have a great effect. For people who are planning on staying in the home for a long time, however, a fixed-rate may be a better option.

The most important thing that a prospective borrower can do is to research the various lending institutions to determine which one has the best rates. There are a wide variety of resources available, including the Internet, and a well-prepared and educated buyer can avoid many pitfalls. It is also advisable to employ the services of a real estate attorney, especially for first-time home buyers. An attorney can spot problem areas in a contract and even negotiate better rates and other considerations.

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