Mortgage Concepts is a recurring video series covering best practices and compliance education for California mortgage loan originators (MLOs). This video breaks down critical elements of an adjustable rate mortgage (ARM). For course credit toward renewing your NMLS license, visit firsttuesday.us.
ARM awareness
During periods of rising fixed rate mortgage (FRM) rates, homebuyers lean into adjustable rate mortgages (ARMs) due to their interest rate being lower than FRM rates. This interest rate spread allows the consumer using an ARM to qualify for a greater amount of purchase-assist funding for the same monthly payment as on an FRM.
While ARM rates have gradually moved upward since 2012, so have FRM rates — until January 2022 when the ARM rate moved higher than the FRM rate. As a consequence of upward rate movements on ARMs, monthly payments charged the consumer rise as they are not fixed for the life of the mortgage as are FRMs.
On an adjustment in an ARM interest rate, monthly payments paid by the consumer are adjusted to maintain the amortization period for pay off of the principle over the life of the ARM. As a result, ARMs have a complex design compared to a traditional fixed rate mortgage (FRM).
The Mortgage Concepts video above reviews the elements of an ARM and breaks down the financial risks for a consumer seeking ARM funds to buy or refinance a home.
Elements of an adjustable rate mortgage
A homebuyer applying for an ARM needs a lot of information:
- to learn about the function and outcome of each element in the rate-and-payment adjustment formula of an ARM; and
- to become aware of the risks posed by future financial burdens brought on by the interaction of these ARM elements.
All ARMs contain four critical elements:
- an introductory interest rate,
- an index,
- a margin, and
- an adjustment interval.
The introductory interest rate is the initial rate charged on the ARM principal, also called a teaser rate. This rate is fixed for a limited amount of time, called the introductory period, running anywhere from a month to ten years, depending on the type of ARM.
Lenders may set the ARM introductory interest rate at a discount of the index figure to attract borrowers. Typically, the introductory rate is lower than the fully-indexed rate, which is the rate calculated as the sum of the published third-party index figure and the mortgage lenders margin set in the ARM note as further discussed below.
During the Millennium Boom, many lenders determined a homebuyer’s ability to make the monthly payments – underwriting – based solely on this introductory rate. When the rate adjusted, borrowers were often unprepared and thus unable to make the increased payments, a situation known as payment shock.
However, today’s ability-to-repay rules require lenders to underwrite and thus qualify a borrower for an amount of mortgage principal based on a fully-indexed rate, or the highest rate possible on the ARM during the first five years of its term.
The index is one of two components determining the adjusted interest rate after the introductory period. An ARM’s interest rate charge is “tied” to an index — meaning, as the index figure rises and falls, so too does the ARM’s interest rate.
The most common indexes for ARMs include: the 11th District Cost-of-Funds Index, the 12-month Treasury Average, and the Secured Overnight Financing Rate.
The index the lender uses needs to be:
- readily available and verifiable by the borrower; or
- based on a formula or schedule identifying the possible rate increase, and the circumstances triggering the change; and
- beyond the control of the mortgage holder.
Complete transparency is required of the mortgage holder when changing the interest rate on a consumer’s ARM. [Regulation D]
The margin is the other element used to determine the recast interest rate to be charged the consumer after the introductory period expires. The margin consists of a percentage point figure which is added to the index figure to calculate the ARM interest rate charged the consumer for the period following the adjustment.
The margin is the lender’s operating and profit yield which varies as a competitive matter between lenders. The margin is fixed for the life of the mortgage.
As an example, when an ARM index figure is 4%, and the profit margin is 2%, the fully-indexed rate charged the consumer for the ARM is 6%. When the index figure rises to 6%, the fully-indexed rate is 8%.
Lastly, the adjustment interval is the time period between changes in the ARM’s interest rate. ARMs are scheduled to adjust every month, year, three years, or greater depending on the terms of the mortgage note.
On expiration of an adjustment interval, the ARM interest rate is adjusted to equal the sum of the current index figure plus the margin figure set in the mortgage note. In turn and most critical for the consumer is the change in the monthly mortgage payment each time the ARM rate is adjusted.
ARMed with this information, your homebuyer clients applying to originate an ARM can better prepare for the inevitable adjustment of the ARM interest rate and monthly payments to be charged the consumer on a recast.
