Debt Free

Unless you've been on an extended expedition to places where you can't get CNN, you're well aware that ARM is the abbreviation for Adjustable Rate Mortgage. Just what is an adjustable rate mortgage, how does such a mortgage work, why would anyone want one, and how did they get so many people into so much damned trouble, anyway?

When shopping for a house many people are payment shoppers, just as they are when shopping for cars. It's all about the monthly payment. That's why so many people are attracted to the adjustable rate mortgage loan; it keeps their monthly mortgage payment lower than a conventional, fixed rate mortgage product. The problem is that that's only true for a while. Eventually the mortgage payment will rise, and with it will go the home owner's blood pressure. This is because, as the name suggests, the ARM's interest rate adjusts. In case you had any illusions, it adjusts up, and so does the mortgage payment.

When looking at an ARM, you'll be confronted by a set of numbers used to describe the terms of the loan. They'll be stated in fractional looking terms, such as 3/1, 5/1 or 7/1. This is simply the number of years that the initial mortgage interest rate stays the same, and how often it will adjust after that. A 3/1 ARM will stay at the initial rate for 3 years. After that it will adjust every 1 year.

Just how does an ARM adjust? Do the lenders sit around the bar at the country club and pull interest rate numbers out of their....well, you get the picture. Actually the loan's interest rate is tied to an index, which is simply one of several reference interest rates used by major financial institutions. Depending upon the specific index, it is set by the federal government or the applicable financial institutions.

The most common indices used to compute the mortgage interest rate on an ARM are the London Interbank Offered Rate (LIBOR), the Prime Rate, the Cost Of Funds Index (COFI), and 1, 3 or 5 year U.S. Treasury note rates. Ah, but you won't just pay these rates, you'll pay the index rate plus what's called a margin. The margin is just a percentage over the index rate. So, if you have a 5/1 ARM that's tied to the 1 year LIBOR, and your margin is 3%, when your ARM adjusts, you'll pay the current 1 year LIBOR rate plus 3%. Currently the LIBOR is 3.29%, so you'd pay 6.29%. That rate would hold until the next adjustment period, when it would adjust again. In the case of the example 5/1 ARM, it would adjust in 1 year.

There are several other important things to look at in an ARM. One of these are the caps. An ARM cap is simply that, a cap on how much the interest rate can go up. Typically the loan will have lifetime caps and periodic caps. While caps can be beneficial, they can also work against the borrower if there is what's called a carryover provision in the terms of the loan. A carryover lets the lender carry over interest rate increases they couldn't apply because they exceeded the cap.

For example, if your ARM adjusted upwards but was capped at a 2% increase, your lender could only increase the interest rate upwards by 2% in any given period. If the index went up by more than that, say 3%, a carryover provision could let them carry over the extra 1% increase to future adjustment periods and apply it then. So if the index increased 3% this year, but only 1% next year, the lender could increase your mortgage interest rate 2% each year, because the 1% over the cap they couldn't apply in the first year would be carried over and applied the next. Got that??

People love ARMS, especially when they're starting out in their careers, because as they earn more money they can afford a larger payment. The other common strategy, in fact the one that many people counted on, is to refinance the ARM into a fixed rate mortgage loan before the dreaded adjustment occurs. If you have a 5/1 ARM you have a 5 year window to enjoy the low, introductory rate before the loan adjusts (also called resetting) to a higher rate. Most people thought it would be no problem to simply refinance their mortgage before they got caught with the higher rate, because as home values rose, they'd have enough equity in the home to qualify for a fixed rate mortgage with a low interest rate.

That's how so many people got into so much trouble with ARMs. They did two things that came back to bite them. They got too much house, and they thought real estate appreciation would continue unabated, or at least until they could refinance. The problem arose because in many areas the real estate markets were showing double digit annual appreciation for the better part of a decade. People forgot that that's not really how things work over the long term. Eventually the chickens will come home to roost; and they'll crap all over the coop when they do so.

Here's a common example that occurred in many areas. First of all, you'll note that this was a classic example of “the bigger they are, the harder they fall”. Most of the big problems happened in areas that saw the largest and fastest home value appreciation, such as Las Vegas, south Florida and Southern California. If a borrower got a 5/1 ARM tied to the LIBOR for $400,000 in 2003, in 2008 their ARM is due for a reset. If their initial interest rate was 4.75% their monthly P&I payment would be about $2,087 per month. Now, when their mortgage resets (if it was calculated today), they'll be paying $2,473 per month.

Now $390 a month isn't chicken feed (the price of chicken feed's going up, just like everything else), but it could have been even worse. Many people used special mortgage products, like interest only loans to buy their properties. That keeps the monthly payment low, because you're only paying the interest for the first part of the loan. As with the standard ARM however, the interest only loan will eventually reset, leaving you holding the bag for both the principal and the interest. The increase is compounded because the interest rate can also adjusts upwards at the same time, depending upon the terms of the loan. So, you could be hit with the added costs of repaying the principal, but also an increasing interest payment at the same time.

How the majority of people got into trouble with their ARMs, was they either neglected to refinance in time (very stupid financial decision) or their home's value dropped to the point where they couldn't refinance because they owe more on the house than it's worth (that also had it's roots in a stupid financial decision, although not nearly as poor a decision as neglecting to refinance before it was too late). When this happens, you can't get a new mortgage for enough to pay off the ARM because the value of the collateral used to secure the new loan (your house) isn't enough to cover the loan.

To compound matters, many lenders are skittish that home values will continue dropping in many regions, so they are requiring higher down payments than in the past. If they want a 20% down payment, you'll need 20% equity in your house in order to refinance it. This is something many people just don't have.

So, there you go. That's what an adjustable rate mortgage loan is, and that's how so many home owners got into so much trouble with them. Here's to helping you get debt free, and have a great weekend.