The London Interbank Offered Rate Index (LIBOR) is an average of the interest rates that major international banks charge each other to borrow U.S. dollars in the London money market. Like the U.S. Treasury indexes, LIBOR tends to move and adjust quite rapidly to changes in interest rates.
This international interest-rate index became increasingly popular as more foreign investors bought American mortgages as investments. Not surprisingly, these investors like ARMs tied to an index that they understand and are familiar with.
Be sure to ask your lender how the index tied to the ARM you’re considering has changed in the last five to ten years. Figure 5-2 helps you compare the volatility of the most common indexes.
Add the margin
The margin, or spread as it’s also known, on an ARM is the lenders’ profit, or markup, on the money that they lend. Most ARM loans have margins of around 2.5 percent, but the exact margin depends on the lender and the index that lender is using. When you compare several loans that are tied to the same index and are otherwise the same, the loan with the lowest margin is better (cheaper) for you.
All good things end sooner or later. After the initial interest rate period expires, an ARM’s future interest rate is determined, subject to the loan’s interest rate cap limitations as explained later in this section, by adding together the loan’s current index value and the margin.
The following formula applies every time the ARM’s interest rate is adjusted:
Index margin interest rate
For example, suppose that your loan is tied to the one-year Treasury security index, which is currently at 2.5 percent plus a margin of 2.25 percent. Thus, your loan’s interest rate is
2.5% 2.25% 4.75%
FIGURE 5-2:
Selected index rates for ARMs over 30-year period.
Source: HSH.com
This figure is known as the fully indexed rate. If a loan is advertised with an initial interest rate of, say, 3.5 percent, the fully indexed rate (in this case, 4.75 percent) tells you what interest rate this ARM would rise to if the market level of interest rates, as measured by the one-year Treasury security index, stays at the same level.
Always be sure to understand the fully indexed rate on an ARM you’re considering.
To avoid any surprises, you also should know what the payment will be for various potentially higher interest rates during the life of your loan, including the maximum rate, so you fully understand what the maximum possible monthly payment is. Ask the lender and/or your mortgage broker to provide this payment information.
How often does the interest rate adjust?
Although some ARMs have an interest rate adjustment monthly, most adjust every 6 or 12 months, using the mortgage-rate determination formula discussed previously. In advance of each adjustment, the mortgage lender should mail you a notice, explaining how the new rate is calculated according to the agreed-upon terms of your ARM.
The less frequently your loan adjusts, the less financial risk you’re accepting. In exchange for taking less risk, the mortgage lender normally expects you to pay more — such as a higher initial interest rate and/or higher ongoing margin.
What are the limits on rate adjustments?
As discussed earlier in this chapter, despite the fact that an ARM has a formula for determining future interest rates (index + margin = interest rate), a good ARM limits the magnitude of change that can occur in the actual rate you pay. These limits, also known as rate caps, affect each future adjustment of an ARM’s rate fol- lowing the expiration of the initial rate period.
Two types of rate caps exist:
ằ Periodic adjustment caps: These caps limit the maximum rate change, up or down, allowed at each adjustment. For ARMs that adjust at six-month intervals, the adjustment cap is generally plus or minus 1 percent. ARMs that adjust more than once annually generally restrict the maximum rate change allowed over the entire year as well. This annual rate cap is typically plus or minus 2 percent.
ằ Lifetime caps: Never, ever, ever take an ARM without a lifetime cap. This cap limits the highest rate allowed over the entire life of the loan. ARMs commonly have lifetime caps of 5 to 6 percent higher than the initial start rate.
Without a lifetime cap, your possible loan payment could grow to the moon if interest rates soar again as they did in the early 1980s when rates peaked at more than 18 percent. Be sure you can handle the maximum possible payment allowed on an ARM if the interest rate rises to the lifetime cap.
You may be wondering why we stress that interest rate adjustments are capped both up and down. Who cares how much rates can go down? You will, if rates drop rapidly and your ARM responds like molasses on a subzero winter morning. As we discuss in Chapter 11, a good reason to refinance an ARM is to lower the periodic and lifetime adjustment caps accordingly if interest rates decline significantly.
Does the loan have negative amortization?
On a normal mortgage, as you make mortgage payments over time, the loan bal- ance you owe is gradually reduced through a process called amortization (see Chapter 4). Some ARMs, however, cap the increase of your monthly payment but don’t limit how much the interest rate can increase. Thus, the size of your mort- gage payment may not reflect all the interest that you actually currently owe. So rather than paying the interest that’s owed and paying off some of your loan principal balance every month, you may end up paying some (but not all) of the current interest that you owe.
Thus, the extra, unpaid interest that you still owe is added to your outstanding debt. This process of increasing the size of your loan balance is called negative amortization. Negative amortization is like paying only the minimum payment required on a credit card bill. You continue accumulating additional interest on the balance as long as you make only the minimum monthly payment. However, doing this with a mortgage defeats the purpose of your borrowing an amount that fits your overall financial goals (as we discuss in Chapter 1).
Some lenders try to hide the fact that an ARM they’re pitching you has negative amortization. How can you avoid negative amortization loans?
ằ Ask. As you discuss specific loan programs with lenders or mortgage brokers, be sure to tell them you don’t want a loan with negative amortization. Specifically ask them if the ARM they’re suggesting has it or not.
You must be especially wary of being pitched negative amortization loans if you’re having trouble finding lenders willing to offer you a mortgage (in other words, you’re considered a credit risk). Remember Robert’s take on the old adage, “If it’s too good to be true, it’s too good to be true.”
ằ If the loan has a monthly adjustment, ask again. Monthly adjusting ARMs are often a warning sign of a negative amortization loan. Another red flag is an ARM with annual payment caps rather than semi-annual or annual interest rate adjustment caps.