ARMs - Deep Dive into Adjustable Rate Mortgages

An Adjustable-Rate Mortgage (ARM) - also known as a variable-rate mortgage - has an interest rate that changes periodically throughout the life of the loan.

An ARM has not been the mortgage of choice for many homeowners since before the financial crisis of 2008. When interest rates are at historic lows like the market saw from 2010-2020, the benefits of ARMs did not out weigh the inherent risk of the product.

Now that we are seeing interest rates rise, my argument is that that thinking needs to be revisited. Put simply, the benefits of an ARM loan is a lower rate when you purchase the home.

The first thing to do is understand the structure of the program. An ARM is expressed as 5/1, 7/1, 10/1, 5/6, or 7/6. The first number is the amount of years a low "introductory rate" is in effect. The second number is how frequently the rate will adjust after the introductory rate.

As an example - a home purchase with a 7/1 ARM loan at 5% interest.

Years 1-7 (introductory period): Interest Rate = 5%

Years 7-30: Interest Rate = adjusts every 1 yr based on the selected index.

Another example - Home purchase with a 5/6 ARM loan at 5%

Years 1-5 (introductory period): Interest Rate = 5%

Years 5-30: Interest Rate = adjusts every 6 months based on the selected index.

Next, is to understand how the rate is determined after the introductory rate. After the intro period, the rate is calculated as follows:

Index + Margin = Rate

Index = SOFR 30-day average. This is calculated by the Federal Reserve of NY.

Margin = the fixed spread set by the mortgage company at the time of origination. (This is typically between 2-3%).

As an example - let's say today (7/6/22), the introductory rate has come to an end and it is time for your loan to adjust. When you closed on your loan, the margin was 3%.

Index Today (1.21) + Margin (3) = 4.21% - this would be your new interest rate

Again, this is recalculated either annually or semi-annually depending on the loan option your chose at origination.

The third thing to understand about ARMs are the "caps" set on the mortgage.

To save borrowers from a dramatic increase in monthly payment (known as "payment shock") the mortgage company will have interest rate caps on every ARM loan that is originated. The typical caps are expressed as 2/2/5. The caps are broken down this way:

Initial max interest rate increase / max increase for each period / max overall increase.

Put another way - after the intro period, the max the rate can increase is 2%. The max the rate can increase each year after that is 2%. The max the rate can increase over the life of the loan is 5%.

Example:

Let's say you originated a loan in 2017 as a 5/1 ARM with caps of 2/2/5 at an interest rate of 2.5%. It is now 2022 and your introductory has expired.

The highest the rate can increase initially in 2022 is 4.5%. For 2023 and 2024, the rate has a cap at 6.5% and 8.5%, respectively. However, the loan also has a max overall cap at 7.5% (2.5% + 5%), so the rate can no longer go higher than 7.5%. The rate will stay at 7.5% until the index decreases.  

Again, as mentioned above, the rate is based on the index + margin. So, the scenario above is the worst case scenario for the ARM loan, assuming all the caps are used.

Let's look at a historical example to see where the rate would have been over the previous 10 yrs (if you want to follow along select the NY FED link above):

Say a loan was originated on July 1, 2014. The loan was a 5/1 ARM with caps at 2/2/5. The initial rate is 4% and the margin is 3% for the mortgage company.

Yr 1 - 5 (2014 - 2019): Rate = 4%

Yr 6 (July 1, 2019): Rate = 5.38% [Index (2.38) + Margin (3)]

Yr 7 (July 1, 2020): Rate = 3.07% [Index (.07) + Margin (3)]

Yr 8 (July 1, 2021): Rate = 3.05% [Index (.05) + Margin (3)]

Yr 9 (July 1, 2022): Rate = 4.5% [Index (1.50) + Margin (3)]

Now, let's look at this option from a more practical point of view - what would have been the monthly savings on the ARM vs a fixed rate option?

Looking at the same example above, let's assume that the loan was originated at $500,000 in 2014 with a rate of 4.25% and compare the monthly expenses over 10 yrs to an ARM.

Fixed Rate (4.25%): Monthly Payment = $2,460 | Payments over 10 yrs = $295,200

ARM (see breakdown above):

Yrs 1-5: Monthly = $2,387 | Payments over 5 yrs = $143,220

Yr 6: Monthly = $2,801 | Annual = 33,612

Yr 7: Monthly = $2,127 | Annual = 25,524

Yr 8: Monthly = $2,122 | Annual = 25,464

Yr 9: Monthly = $2,533 | Annual = 30,396

Payments over 10 yrs = $258,216

Savings over the last 10 yrs = $36,984

Of course, there are significant drawbacks to ARM loans that cannot be ignored. Looking at the example above, it would be hard to see your payment jump over $400 from $2,387 to $2,801 between yrs 5-6. That is the inherent risk with ARM loans.

These options are best suited for the following circumstances:

1. A buyer that does not think they will be in the home longer than 5 yrs.

On average, most people move about 11-12 times in their life. That means the average person will move every 6-7 years. It is not uncommon to assume a buyer may never see the adjustment occur in the ARM loan before they sell the home.

2.   The home is NOT your forever home. The buyer is looking at the property as an investment more than a home.

In the same vein as number one, it is important to remember that real estate is most American's number one source of net worth. The home is an investment.

3.   The buyer is intelligent with his/her money, has significant savings, and can weather a storm of higher payments.

If you are paycheck to paycheck, or haven't accumulated a 8-12 reserve savings account, this option is NOT for you. As you can see in the example above, a buyer has to be willing and able to endure the higher payments for a time being to see large savings over time.

I expect through the rest of 2022 and into 2023, the market will begin to see more and more ARM products emerge in the market. If you are someone who understands the risks associated with an ARM loan, there can be significant benefit for you and your investment.

If you would like to discuss these options further or want a custom scenario run for you and your financial situation, please reach out to michael@nuwavelending.com or call 615-969-6889.