The initial interest rate for an ARM may be:
- the fully indexed rate (the margin plus the index rate); or
- a lower rate, which may be called a “discounted index rate,” a “start rate,” a “teaser rate,” or the note rate (as it was the rate expressed in the mortgage note). This rate is lower than the fully indexed rate and lower than that for an FRM, making the ARM payments more affordable than those for an FRM for the same loan amount.
The initial rate and payment amount on an ARM remain in effect for a limited period of time, ranging from just one month to five years or more. When that initial rate period has expired, the rate will be adjusted based on the index rate at that time and any caps.
The lender’s fully indexed one-year ARM rate (index rate plus margin) is currently 6%. At that rate, the monthly payment for the first year of a particular loan would be $1,199.10. But the lender is offering an ARM with a discounted initial fixed rate of 4% for the first year. At the 4% rate, the monthly payment for the first year would be just $954.83. The adjustable-rate that goes into effect starting in year 2 of the loan will vary, and most likely rise, based the index rate that will fluctuate during the loan’s term.
When the initial rate is discounted, it and the loan payments can vary greatly from the rates and payments later in the loan term, even if interest rates are stable. When a loan’s APR is significantly higher than its initial rate, it is likely that the rate and payments will be much higher when the loan adjusts, even if current interest rates remain the same.
A lower initial ARM rate provides an incentive for a borrower to assume some of the interest risk (i.e., the risk of rising interest rates during the loan period) that the lender has with a fixed-rate loan. A lender making a 5 percent fixed-rate loan would receive 5 percent interest whether current interest rates were 4 percent or 10 percent. If the current rates were 10 percent, he could be paying a higher rate of interest for the money he is borrowing than he is receiving from his existing fixed-rate borrowers. An ARM interest rate, however, will increase when current rates increase, so the lender is able to pass on some or all of the interest risk to the borrower. This means ARM loan payments generally rise when interest rates rise and fall when interest rates fall.
A loan applicant should be advised to seriously consider whether he will be able to afford the higher payments required when the loan rate is adjusted:
- if interest rates are rising rapidly at the time of the application.
- if his initial rate is discounted. Because use of a deeply discounted initial rate exposes the borrower to the risk of payment shock and negative amortization, many lenders now require, and for some types of loans, the law now requires, that the borrower is qualified based on the fully indexed rate.
A 30-year $150,000 loan has a one-year ARM rate (index rate plus margin) at 6%. However, the lender is offering a 4% rate for the first year. With the 4% rate, the monthly payment for this loan is $716.12 during the first year.
In the second year, the index rate stays the same. The monthly payment amount still increases, based on the 6% ARM rate, to $899.33.
The Adjustment Period
For a loan with an adjustable interest rate, the interest rate and loan payment are subject to change.
The terms of the loan will specify the frequency of monthly payment changes. It may specify that the interest rate and monthly payment are subject to change every month, quarter, year, three years, five years, or some other term. The period between rate changes is called the adjustment period.
ARMs may have limits on the amount of any one adjustment and/or the amount of the total adjustment from the note rate over the entire term of the loan. These limits are referred to as caps. They may limit the percentage by which the interest or the payment can increase at each adjustment.
Interest Rate Caps
One such limit is an interest rate cap, which limits the amount by which the loan’s interest rate may change.
One version of this cap is the periodic adjustment cap. This cap limits the amount of the increase, and often the decrease, in the interest rate at the time of any adjustment. With a 1 percent cap, if the current interest rate being charged on the loan is 6 percent, the lender cannot raise the interest rate above 7 percent at the time of the next adjustment, whether the adjustment period is one year or five years. When the adjustment period is one year, the lender may refer to the interest rate cap as an “annual cap.”
A new rate that is subject to an interest cap at the time of an adjustment is equal to the lower of:
- the index rate plus margin; or
- the current rate plus the cap.
A lifetime (overall) cap limits the interest rate increase, and perhaps the total rate decrease, over the entire term of the loan. Most ARMs have a lifetime cap.
An ARM with a 1/6 cap has a 1 percent cap per year and a 6 percent lifetime cap.
Interest Rate Caps
Some ARMs have three interest rate caps:
- An initial cap
- A periodic cap (usually annual)
- A lifetime cap
If the initial adjustment cap and annual caps are the same (e.g., 1 percent) and the lifetime cap is 6 percent, the ARM may be described as either a 1/1/6 or just as a 1/6 caps.
Some ARMs allow a larger rate change at the first adjustment and then apply a periodic rate adjustment cap to all future adjustments. An ARM may have an initial fixed rate period of three years, after which the first adjustment can increase the rate by up to 2 percentage points, with any further increase limited to 1 percentage point, and with no lifetime cap. This may be advertised as a 3/2/1 ARM.
A drop in interest rates does not always lead to a drop in a borrower’s monthly payments. With an ARM that has an interest rate cap, the cap may hold the rate and payment below what it would have been if the change in the index rate had been fully applied. The increase in the interest that was not imposed because of the rate cap might carry over to future rate adjustments. This is called carryover. So at the next adjustment date, the payment might increase even though the index rate has stayed the same or declined.
In general, a loan’s rate can increase at the time of any scheduled adjustment when the lender’s fully indexed ARM rate (the index plus the margin) is higher than the rate the borrower is paying before that adjustment.
In addition to interest caps, an ARM may have a payment cap. A payment cap limits the percentage increase of the required minimum periodic payment from the previous periodic payment, regardless of the change in the index or the interest rate, which if paid in that amount will cause the deferring of some of the interest.
The payment cap limits only the amount the required minimum scheduled payment can increase. It does not limit interest rate increases. Therefore, payments limited by such caps may not cover all the interest charged on the loan. If that is the case, the unpaid interest is automatically added to the debt and interest is then charged on that amount. Because any unpaid interest is added to the mortgage principal, the borrower owes more than the amount originally borrowed. When a payment cap limits the increase to a borrower’s required minimum monthly payments and the deferred interest is added to the amount owed on the loan, this is called negative amortization.
Some ARMs with payment caps do not have periodic interest rate caps.