Understanding Adjustable Rate Mortgages When Rate Are Rising

The Federal Reserve has raised interest rates five times in the past two years. Hearing that additional rate hikes are on the horizon, consumers with Adjustable Rate Mortgages (ARMs) are feeling anxious about how the rate hikes will impact their monthly payment once the initial low interest rate reaches the end of the term.

Whether you currently have an ARM, or are considering an ARM, understanding the components and terminology of an adjustable rate mortgage will help you decide if an ARM is the best loan product to meet your long-term financial goals. Let’s breakdown the essentials:

Start Rate/Initial Fixed Period: The start rate is the interest rate that is fixed for a specific period of time. That time period may be three, five, seven, 10, or even 15 years depending on the mortgage product. Loans with initial fixed terms are commonly known as 5/1, 7/1, 10/1 or 15/1 ARMs. After the initial period, the rate will then convert from a fixed to an adjustable, and the rate and payment will be adjusted annually by adding the index plus margin. The annual increase will be limited by the caps specified in the note (see below).

Index: The index is the volatile component of an ARM loan. An index rises and falls based on economic fluctuations and is the cost the lender pays to borrow the funds in the credit markets. Banks use a variety of indices, the most common being the LIBOR (London Inter-Bank Offer Rate).

Margin: The margin is the fixed percentage that is added to the index to determine the rate once the start rate/initial fixed period has ended. The margin is the lender’s profit.

Caps: The caps limit the amount that a rate can increase or decrease once the introductory period is over, annually and over the life of the loan. Caps are made up of three figures and can be displayed as 2/2/5. The first “2” represents the most the interest rate can increase after the initial fixed period ends; the second “2” represents the most the rate can increase each year thereafter; and the “5” represents the maximum the rate can increase over the life of the loan.

For example, if a borrower locks in a 5/1 ARM with a start rate/initial fixed period at 2.50% and caps of 2/2/5, the loan payment would be fixed for five years at an interest rate of 2.50%. At the end of the five-year term, the lender would then add the index plus the margin to determine the current interest rate. In this example, the adjustment is capped to either index plus margin or 2% whichever is the leastbetween the two. Knowing the caps, once the start rate ends, is essential.

So, what happens after the term ends? Using the current 1-year LIBOR index value of 2.79% and adding a margin of 2.50%, the market rate would be 5.29%. However, the rate cannot increase more than 2% the first year which would limit the increase to 4.50% for one year (2.50% start rate + 2% cap). The payment would be fixed at 4.50% for one year. Each year thereafter, the lender would adjust the payment.

If the following year the 1-year LIBOR value is 3.79% plus the margin of 2.50%, the market rate would be 6.29%. Because the index plus margin is lower than the 2% annual increase cap, the payment would be fixed for another year at an interest rate of 6.375% (most lenders will round this figure to the nearest .125%).

Lastly, if the following year the 1-year LIBOR value is 5.25% plus the margin of 2.50%, the market rate would be 7.75%. Even though the index plus margin is less than a 2% increase from the previous year, the maximum the rate can increase is 7.50% (2.50% start rate + 5% cap) over the life of the loan. Being that the lifetime cap has been reached, the payment would be fixed at 7.50% for the remainder of the loan term or until rates decline.

Another common cap combination in the marketplace is a 5/2/5 cap. With this combination, when the start/initial rate ends, the first interest rate adjustment cap is set at the same level as the lifetime adjustment cap, meaning that the initial rate could potentially increase 5%. If the start/initial rate is 2.50% and the first adjustment raises the rate to 7.50%, borrowers will experience significant payment shock that could create a major financial hardship.

ARM loan products can serve as great alternatives to 30-year fixed rate mortgages. Lower initial start rates have helped borrowers save hundreds of dollars in monthly payments. But, knowing the components of an ARM are essential to understanding how a rising interest rate market can impact your monthly payment. Knowledge is the key to protecting your monthly cashflow and your home!

If you currently have an ARM, now would be the perfect time to review your loan before additional rate hikes occur and explore alternative products that better meet your financial goals. For a complimentary review of your mortgage loan, please feel free to either phone me at 925-552-3863 or email me at jbrydges@rpm-mtg.com.



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