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Every ARM is tied to an interest rate index. An index has three relevant features:availibility, level, volatility. All the common ARM indexes are readily available from a published source, with the exception of one called the Cost of Savings Index, or COSI. In principle, a lower index is better for a borrower than a higher one. However, lenders take account of different index levels in setting the margin. A 3% index with a 2% margin provides the same FIR as a 2% index with a 3% margin. Assuming volatility is the same, there is nothing to choose between them.
An index that is relatively stable is better for the borrower than one that is volatile. The stable index will increase less in a rising rate environment. While it will also decline less in a declining rate environment, borrowers can take advantage of declining rates by refinancing.
The most stable of the more widely-used rate indexes is the 11th District Cost of Funds Index, referred to as COFI (not 'coffee'). Most of the others are significantly more volatile. These include the Treasury series of constant (one-, two-, or three-year) maturity, one-month and six-month Libor, six-month CDs and the Prime Rate.
Another series known as MTA is a 12-month moving average of the one-year Treasury constant maturity series. MTA is a little more volatile than COFI but less volatile than the other series.
An ARM should never be selected based on the index alone. That would be like buying a car based on the tires. But if an overall evaluation (see below) indicates that two ARMs are very close, preference could be given to the one with the more stable index.
How the Monthly Payment on an ARM Is Determined: ARMs fall into two major groups that differ in the way in which the monthly payment of principal and interest is determined: fully amortizing ARMs and negative amortization ARMs.
Fully Amortizing ARMs adjust the monthly payment to be fully amortizing whenever the interest rate changes. The new payment will pay off the loan over the period remaining to term if the interest rate stays the same.
For example, a $100,000 30-year ARM has an initial rate of 5%, which holds for five years, after which the rate is adjusted every year. (This is referred to as a '5/1 ARM.') The payment of $536.83 for the first five years would pay off the loan if the rate stayed at 5%. In month 61, the rate might increase to, say, 7%. A new payment of $649.03 is then calculated, at 7% and 25 years, which would pay off the loan if the rate stayed at 7%. As the rate changes each year thereafter, a new payment is calculated that would pay off the loan over the remaining period if that rate continued.
Negative Amortization ARMs allow payments that don't fully cover the interest. They have one or more of the following features:
- Payment Rate Below the Interest Rate: The payment rate,which is the interest rate used to calculate the payment, maybe below the actual interest rate. If the payment rate is so low that the initial payment does not cover the interest, the result will be negative amortization.
- More Frequent Rate Adjustments than Payment Adjustments:
If, the rate adjusts every month but the payment adjusts every year, a large rate increase within the year will lead to negative amortization.
- Payment Adjustment Caps: If a rate change is large and a payment adjustment cap limits the size of a change in payment, the result will be negative amortization.
Virtually all ARM's are designed to fully amortize over their term. This means that negative amortization can only be temporary and at some point or points in the ARM's life history the monthly payment must become fully amortizing.
Two contract provisions are used to assure that negative amortization ARM's pay off at term.
1) A recast clause requires that periodically, usually every five years, the payment must be adjusted to the fully amortizing
2) A negative amortization cap is a maximum ratio of loan balance to original loan amount, for example, 110%. If that maximum is reached, the payment is immediately adjusted to the fully amortizing level, overriding any payment adjustment cap. In a worse case scenario, the required payment increase may be very large.
Identifying ARMs: There are no industry standards for identifying ARMs and practices vary across lenders. Some identify their ARMs by the index used, e.g., 'COFI ARM' or 'six-month Libor ARM. Some identify their ARMs by the rate adjustment periods, e.g., '5/1' or '3/3.'
None of these shorthand descriptions are of much use to borrowers because there are so many differences within each. Indeed, even if the features of each were standardized, to compare one type of ARM with another, one needs to know exactly what those features are.
Selecting an ARM to Qualify: It is easier to qualify with an ARM than with an FRM. In deciding whether an applicant has enough income to meet the monthly payment obligation, lenders usually use the initial interest rate on an ARM to calculate the payment, even though the rate may rise at the end of the initial rate period. That's why, when market interest rates increase, ARM's become more common and FRM's less common. Some borrowers who could have qualified with an FRM at the lower rates, now require an ARM to qualify. However, many borrowers who appear to require an ARM to qualify in fact could qualify with an FRM. It just takes a little more work.
Taking Advantage of Low Initial Rates: Borrowers with short time horizons can take advantage of the initial interest rates that are lower on ARM's than on FRM's. For example, at a time when a borrower is quoted 6.5% on a 30-year FRM, the quoted initial rates on 3/1,5/1,7/1, and 10/1 ARM's might be 6%, 6.125%, 6.25%, and 6.375%, respectively.
The correct choice depends on how long the borrower expects to have the loan and on the borrower's attitude to risk. For example, a borrower who expects to hold the mortgage for six years might play it safe by selecting a 7/1. Or, he might take the 5/1 on the grounds that the savings over five years justifies taking the risk of having to pay a higher rate in year six.
Borrowers who take this risk, whether deliberately as in the example above, or inadvertently because they aren't sure how long they will hold the loan, should consider what can happen at the end of the initial rate period. Suppose the borrower deciding between the 5/1 and 7/1, for example, finds that the indexes, margins, and maximum rates are the same, but the rate adjustment caps are 2% on the 5/1 and 5% on the 7/1. This could tilt the decision toward the 5/1.
If the ARM's being compared differ in a number of ways, however, comparing one with another (or with an FRM) can be very confusing. In this situation, borrowers with short time horizons seeking to take advantage of low initial rates on ARM's are no different than borrowers with longer horizons who seek to pay less on the ARM over the life of the loan and are prepared to take the risk that they will pay more. Both should analyze the potential benefits and risks with calculators, as explained below.
Gambling on Future Interest Rates: Taking an ARM (when an FRM is an option) is a gamble, and the question is whether it is a good gamble in any particular case. A good gamble is one where the borrower can reasonably expect that the Interest Cost (IC) will be lower on the ARM than on a comparable FRM over the period the mortgage is held; and where the borrower won't face extreme hardship if interest rates explode.
Information Needed: All the calculators require the following information about each ARM:
Basic Loan Information
- New loan amount or existing loan balance .
- Initial interest rate on new loan or current rate on existing loan .
- New loan term or remaining term on existing loan, in months .
Interest Rate Index
- Selected index, e.g., 11th district cost of funds or 'COFI'
- Margin that is added to interest rate index
First Rate Adjustment
- Number of months to first rate adjustment.
- Maximum interest rate change on first rate adjustment .
- Subsequent Rate Adjustments
- Duration, in months, between subsequent rate adjustments
- Maximum interest rate change on subsequent rate adjustments
- Maximum/Minimum Rates
- Maximum interest rate over life of mortgage .
- Minimum interest rate over life of mortgage .
On negative amortization ARMs, the following is also needed:
- Payment Information
- Initial monthly payment of principal and interest
- Payment adjustment period, in months
- Payment adjustment cap, in percent
- Payment recast period, in years Negative amortization cap, in percent