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An adjustable rate mortgage (ARM) is a mortgage loan where the interest rate on the note is periodically adjusted based on a variety of indices. Among the most common indices are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). A few lenders use their own cost of funds as an index, rather than using other indices. This is done to ensure a steady margin for the lender, whose own cost of funding will usually be related to the index. Consequently, payments made by the borrower may change over time with the changing interest rate (alternatively, the term of the loan may change). This is not to be confused with the graduated payment mortgage, which offers changing payment amounts but a fixed interest rate. Other forms of mortgage loan include the interest only mortgage, the fixed rate mortgage, the negative amortization mortgage, and the balloon payment mortgage. Adjustable rates transfer part of the interest rate risk from the lender to the borrower. They can be used where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate falls and loses out if interest rates rise.

Adjustable rate mortgages are characterized by their index and limitations on charges (caps). In many countries, adjustable rate mortgages are the norm, and in such places, may simply be referred to as mortgages.

All adjustable rate mortgages have an adjusting interest rate tied to an index.

In Western Europe, the index may be the TIBOR or Euro Interbank Offered Rate (EURIBOR).

Six common indices in the United States are:

- 11th District Cost of Funds Index (COFI)
- London Interbank Offered Rate (LIBOR)
- 12-month Treasury Average Index (MTA)
- Constant Maturity Treasury (CMT)
- National Average Contract Mortgage Rate
- Bank Bill Swap Rate (BBSW)

In some countries, banks may publish a prime lending rate which is used as the index. The index may be applied in one of three ways: directly, on a rate plus margin basis, or based on index movement.

A directly applied index means that the interest rate changes exactly with the index. In other words, the interest rate on the note exactly equals the index. Of the above indices, only the contract rate index is applied directly.

To apply an index on a rate plus margin basis means that the interest rate will equal the underlying index plus a margin. The margin is specified in the note and remains fixed over the life of the loan. For example, a mortgage interest rate may be specified in the note as being LIBOR plus 2%, 2% being the margin and LIBOR being the index.

The final way to apply an index is on a movement basis. In this scheme, the mortgage is originated at an agreed upon rate, then adjusted based on the movement of the index. Unlike direct or index plus margin, the initial rate is not explicitly tied to any index; the adjustments are tied to an index.

- Initial interest rate. This is the beginning interest rate on an ARM.
- The adjustment period. This is the length of time that the interest rate or loan period on an ARM is scheduled to remain unchanged. The rate is reset at the end of this period, and the monthly loan payment is recalculated.
- The index rate. Most lenders tie ARM interest rates changes to changes in an index rate. Lenders base ARM rates on a variety of indices, the most common being rates on one-, three-, or five-year Treasury securities. Another common index is the national or regional average cost of funds to savings and loan associations.
- The margin. This is the percentage points that lenders add to the index rate to determine the ARM's interest rate.
- Interest rate caps. These are the limits on how much the interest rate or the monthly payment can be changed at the end of each adjustment period or over the life of the loan.
- Initial discounts. These are interest rate concessions, often used as promotional aids, offered the first year or more of a loan. They reduce the interest rate below the prevailing rate (the index plus the margin).
- Negative amortization. This means the mortgage balance is increasing. This occurs whenever the monthly mortgage payments are not large enough to pay all the interest due on the mortgage. This may be caused by the payment cap contained in the ARM when are high enough that the principal plus interest payment is greater than the payment cap.
- Conversion. The agreement with the lender may have a clause that allows the buyer to convert the ARM to a fixed-rate mortgage at designated times.
- Prepayment. Some agreements may require the buyer to pay special fees or penalties if the ARM is paid off early. Prepayment terms are sometimes negotiable.

It should be obvious that the choice of a home mortgage loan is complicated and time consuming. As a help to the buyer, the Federal Reserve Board and the Federal Home Loan Bank Board have prepared a mortgage checklist.

Any mortgage where payments made by the borrower may increase over time brings with it the risk of financial hardship to the borrower. To limit this risk, limitations on charges—known as caps in the industry—are a common feature of adjustable rate mortgages. Caps typically apply to three characteristics of the mortgage:

- frequency of the interest rate change
- periodic change in interest rate
- total change in interest rate over the life of the loan, sometimes called life cap

For example, a given ARM might have the following types of caps:

Interest rate adjustment caps:

- interest adjustments made every 6 months, typically 1% per adjustment, 2% total per year
- interest adjustments made only once a year, typically 2% maximum
- interest rate may adjust no more than 1% in a year

Mortgage payment adjustment caps:

- maximum mortgage payment adjustments, usually 7.5% annually on pay-option/negative amortization loans

Life of loan interest rate adjustment caps:

- total interest rate adjustment limited to 5% or 6% for the life of the loan.

Caps on the periodic change in interest rate may be broken up into one limit on the first periodic change and a separate limit on subsequent periodic change, for example 5% on the initial adjustment and 2% on subsequent adjustments.

Although uncommon, a cap may limit the maximum monthly payment in absolute terms (for example, $1000 a month), rather than in relative terms.

ARMs that allow negative amortization will typically have payment adjustments that occur less frequently than the interest rate adjustment. For example, the interest rate may be adjusted every month, but the payment amount only once every 12 months.

Cap structure is sometimes expressed as initial adjustment cap / subsequent adjustment cap / life cap, for example 2/2/5 for a loan with a 2% cap on the initial adjustment, a 2% cap on subsequent adjustments, and a 5% cap on total interest rate adjustments. When only two values are given, this indicates that the initial change cap and periodic cap are the same. For example, a 2/2/5 cap structure may sometimes be written simply 2/5.

Banking regulators pay close attention to asset-liability mismatches to avoid such problems, and place tight restrictions on the amount of long-term fixed-rate mortgages that banks may hold (in relation to their other assets). To reduce this risk, many mortgage originators will sell many of their mortgages, particularly the mortgages with fixed rates.

For the borrower, adjustable rate mortgages may be less expensive, but at the price of bearing higher risk. Many ARMs have "teaser periods," which are relatively short initial fixed-rate periods (typically one month to one year) when the ARM bears an interest rate that is substantially below the "fully indexed" rate. The teaser period may induce some borrowers to view an ARM as more of a bargain than it really represents. A low teaser rate predisposes an ARM to sustain above-average payment increases.

A hybrid ARM features an interest rate that is fixed for an initial period of time, then floats thereafter. The "hybrid" refers to the ARM's blend of fixed-rate and adjustable-rate characteristics. Hybrid ARMs are referred to by their initial fixed-rate and adjustable-rate periods, for example 3/1 for an ARM with a 3-year fixed interest-rate period and subsequent 1-year interest-rate adjustment periods. The date that a hybrid ARM shifts from a fixed-rate payment schedule to an adjusting payment schedule is known as the reset date. After the reset date, a hybrid ARM floats at a margin over a specified index just like any ordinary ARM.

The popularity of hybrid ARMs has significantly increased in recent years. In 1998, the percentage of hybrids relative to 30-year fixed-rate mortgages was less than 2%; within 6 years, this increased to 27.5%.

Like other ARMs, hybrid ARMs transfer some interest-rate risk from the lender to the borrower, thus allowing the lender to offer a lower note rate in many interest-rate environments.

These types of loans are also called "pick-a-payment" or "pay-option" ARMs.

When a borrower makes a Pay-Option ARM payment that is less than the accruing interest, so-called "negative amortization" will occur, which means that the unpaid portion of the accruing interest is added to the outstanding principal balance. For example, if the borrower makes a minimum payment of $1,000 and the ARM has accrued monthly interest in arrears of $1,500, $500 will be added to the borrower's loan balance. Moreover, the next month's interest-only payment will be calculated using the new, higher principal balance.

Option ARMs are popular because they are usually offered with a very low teaser rate (often as low as 1%) which translates into very low minimum payments for the first year of the ARM. During boom times, lenders often underwrite borrowers based on mortgage payments that are below the fully amortizing payment level. This enables borrowers to qualify for a much larger loan (i.e., take on more debt) than would otherwise be possible. When evaluating an Option ARM, prudent borrowers will not focus on the teaser rate or initial payment level, but will consider the characteristics of the index, the size of the "mortgage margin" that is added to the index value, and the other terms of the ARM. Specifically, they need to consider the possibilities that (1) long-term interest rates go up; (2) their home may not appreciate or may even lose value or even (3) that both risks may materialize.

Option ARMs are best suited to sophisticated borrowers with growing incomes, particularly if their incomes fluctuate seasonally and they need the payment flexibility that such an ARM may provide. Sophisticated borrowers will carefully manage the level of negative amortization that they allow to accrue.

In this way, a borrower can control the main risk of an Option ARM, which is "payment shock", when the negative amortization and other features of this product can trigger substantial payment increases in short periods of time.

For example, the minimum payment on an Option ARM can jump dramatically if its unpaid principal balance hits the maximum limit on negative amortization (typically 110% to 125% of the original loan amount). If that happens, the next minimum monthly payment will be at a level that would fully amortize the ARM over its remaining term. In addition, Option ARMs typically have automatic "recast" dates (often every fifth year) when the payment is adjusted to get the ARM back on pace to amortize the ARM in full over its remaining term.

For example, a $200,000 ARM with a 110% "neg am" cap will typically adjust to a fully amortizing payment, based on the current fully-indexed interest rate and the remaining term of the loan, if negative amortization causes the loan balance to exceed $220,000. For a 125% recast, this will happen if the loan balance reaches $250,000.

Any loan that is allowed to generate negative amortization means that the borrower is reducing his equity in his home, which increases the chance that he won't be able to sell it for enough to repay the loan. Declining property values would exacerbate this risk.

Option ARMs may also be available as "hybrids," with longer fixed-rate periods. These products would not be likely to have low teaser rates. As a result, such ARMs mitigate the possibility of negative amortization, and would likely not appeal to borrowers seeking an "affordability" product.

Cash flow ARM mortgages are synonymous with option ARM or payment option ARM mortgages, however it should be noted that not all loans with cash flow options are adjustable. In fact, fixed rate cash flow option loans retain the same cash flow options as cash flow ARMs and option ARMs, but remain fixed for up to 30 years.

- X/Y - Hybrid ARMs are often referred to in this format, where X is the number of years during which the initial interest rate applies prior to first adjustment (common terms are 3, 5, 7, and 10 years), and Y is the interval between adjustments (common terms are 1 for one year and 6 for six months). As an example, a 5/1 ARM means that the initial interest rate applies for five years (or 60 months, in terms of payments), after which the interest rate is adjusted annually. (Adjustments for escrow accounts, however, do not follow the 5/1 schedule; these are done annually.)
- Fully Indexed Rate - The price of the ARM as calculated by adding Index + Margin = Fully Indexed Rate. This is the interest rate your loan would be at without a Start Rate (the introductory special rate for the initial fixed period). This means the loan would be higher if adjusting, typically, 1-3% higher than the fixed rate. Calculating this is important for ARM buyers, since it helps predict the future interest rate of the loan.
- Margin - For ARMs where the index is applied to the interest rate of the note on an "index plus margin" basis, the margin is the difference between the note rate and the index on which the note rate is based expressed in percentage terms. This is not to be confused with profit margin. The lower the margin the better the loan is as the maximum rate will increase less at each adjustment. Margins will vary between 2%-7%.
- Index - A published financial index such as LIBOR used to periodically adjust the interest rate of the ARM.
- Start Rate - The introductory rate provided to purchasers of ARM loans for the initial fixed interest period.
- Period - The length of time between interest rate adjustments. In times of falling interest rates, a shorter period benefits the borrower. On the other hand, in times of rising interest rates, a shorter period benefits the lender.
- Floor - A clause that sets the minimum rate for the interest rate of an ARM loan. Loans may come with a Start Rate = Floor feature, but this is primarily for Non-Conforming (aka Sub-Prime or Program Lending) loan products. This prevents an ARM loan from ever adjusting lower than the Start Rate. An "A Paper" loan typically has either no Floor or 2% below start.
- Payment Shock - Industry term to describe the severe (unexpected or planned for by borrower) upward movement of mortgage loan interest rates and its effect on borrowers. This is the major risk of an ARM, as this can lead to severe financial hardship for the borrower.
- Cap - Any clause that sets a limitation on the amount or frequency of rate changes.

Loan caps provide payment protection against payment shock, and allow a measure of interest rate certainty to those who gamble with initial fixed rates on ARM loans. There are three types of Caps on a typical First Lien Adjustable Rate Mortgage or First Lien Hybrid Adjustable Rate Mortgage.

Initial Adjustment Rate Cap: The majority of loans have a higher cap for initial adjustments that's indexed to the initial fixed period. In other words, the longer the initial fixed term, the more the bank would like to potentially adjust your loan. Typically, this cap is 2-3% above the Start Rate on a loan with an initial fixed rate term of 3 years or lower and 5-6% above the Start Rate on a loan with an initial fixed rate term of 5 years or greater.

Rate Adjustment Cap: This is the maximum amount by which an Adjustable Rate Mortgage may increase on each successive adjustment. Similar to the initial cap, this cap is usually 1% above the Start Rate for loans with an initial fixed term of 3 years or greater and usually 2% above the Start Rate for loans that have an initial fixed term of 5 years or greater

Lifetime Cap: Most First Mortgage loans have a 5% or 6% Life Cap above the Start Rate (this ultimately varies by the lender and credit grade).

- Industry Shorthand for ARM Caps

Inside the business caps are expressed most often by simply the 3 numbers involved that signify each cap. For example, a 5/1 Hybrid ARM may have a cap structure of 5/2/5 (5% initial cap, 2% adjustment cap and 5% lifetime cap) and insiders would call this a 5-2-5 cap. Alternately a 1 year arm might have a 1/1/6 cap (1% initial cap, 1% adjustment cap and 6% lifetime cap) known as a 1-1-6, or alternately expressed as a 1/6 cap (leaving out one digit signifies that the initial and adjustment caps are identical).

- Negative amortization ARM caps

See the complete article for the type of ARM that Negative amortization loans are by nature. Higher risk products, such as First Lien Monthly Adjustable loans with Negative amortization and Home Equity Lines of Credit aka HELOC have different ways of structuring the Cap than a typical First Lien Mortgage. The typical First Lien Monthly Adjustable loans with Negative amortization loan has a life cap for the underlying rate (aka "Fully Indexed Rate") between 9.95% and 12% (maximum assessed interest rate). Some of these loans can have much higher rate ceilings. The fully indexed rate is always listed on the statement, but borrowers are shielded from the full effect of rate increases by the minimum payment, until the loan is recast, which is when principal and interest payments are due that will fully amortize the loan at the fully indexed rate.

- Home Equity Lines of Credit HELOC

Since HELOCs are intended by banks to primarily sit in second lien position, they normally are only capped by the maximum interest rate allowed by law in the state wherein they are issued. For example, Florida currently has an 18% cap on interest rate charges. These loans are risky in the sense that to lenders, they are practically a credit card issued to the borrower, with minimal security in the event of default. They are risky to the borrower in the sense that they are mostly indexed to the Wall Street Journal Prime Rate, which is considered a Spot Index, or a financial indicator that is subject to immediate change (as are the loans based upon the Prime Rate). The risk to borrower being that a financial situation causing the Federal Reserve to raise rates dramatically (see 1980, 2006) would effect an immediate rise in obligation to the borrower, up to the capped rate.

In many countries, it is not feasible for banks to borrow at fixed rates for very long terms; in these cases, the only feasible type of mortgage for banks to offer may be adjustable rate mortgages (barring some form of government intervention).

For those who plan to move within a relatively short period of time (three to seven years), they are attractive because they often include a lower, fixed rate of interest for the first three, five, or seven years of the loan, after which the interest rate fluctuates.

The fact that an adjustable rate mortgage has a lower starting interest rate does not indicate what the future cost of borrowing will be (when rates change). If rates rise, the cost will be higher; if rates go down, the rate will be lower. In effect, the borrower has agreed to take the interest rate risk. Some studies have shown that on average, the majority of borrowers with adjustable rate mortgages save money in the long term; but they have also demonstrated that some borrowers pay more. The price of potentially saving money, in other words, is balanced by the risk of potentially higher costs.

- U.S. Federal Reserve Consumer Handbook on Adjustable Rate Mortgages
- US historical ARM index rates
- US historical mortgage rates, 1982 - present
- Adjustable Rate Mortgage Video and Audio on MarketWatch

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Last updated on Saturday October 11, 2008 at 09:48:42 PDT (GMT -0700)

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This article is licensed under the GNU Free Documentation License.

Last updated on Saturday October 11, 2008 at 09:48:42 PDT (GMT -0700)

View this article at Wikipedia.org - Edit this article at Wikipedia.org - Donate to the Wikimedia Foundation

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