Adjustable Rate Mortgages

With an adjustable rate mortgage (an "ARM"), the mortgage interest expense is recomputed annually.  On recalculation, the interest expense is recomputed so as to conform to the then current market rate of interest.  Because the interest expense will typically be recomputed annually, the Bank is not on the hook (as it is in the case of a fixed rate mortgage) if market rates of interest increase in the future.  Therefore, the Bank will not need to hedge its bet when setting the initial interest rate at the inception of the loan.  This is why ARMs almost always have a significantly lower beginning rate of interest than do fixed rate mortgages. As the interest expense is recomputed annually the monthly mortgage payment will change somewhat each year.

Example:  If Mark and Debbie in the last Example had initially taken out an ARM as opposed to a fixed rate mortgage, they would not have to refinance to obtain the lower rates.  The ARM would automatically adjust downward – if market rates of interest were trending downward – without the need to refinance and incur the associated closing costs, miscellaneous expenses and time that go along with refinancing a significant debt obligation like a mortgage loan.

Thus, if market rates of interest are stable or trending downward, the ARM significantly trumps the fixed rate mortgage.  Conversely, if market rates of interest rise significantly in the future, the ARM would be less attractive as compared to the fixed rate mortgage.

How the variable rate of interest on an ARM is computed

All ARMs are not created equal.  Apart from the "teaser rate" issue that I will address below, the critical factor with an ARM is the interest index that it employs.  Remember that the interest rate on the ARM will typically be readjusted up or down each year as the market rate of interest varies.  How is this change in market rates of interest determined?  It would be a function of the interest rate "index," which will be fully disclosed to you at the inception of the ARM.  The most common index employed nationwide on ARMs is the Federal Reserve Funds Index.  This index very accurately measures variations in market rates of interest as it measures the interest expense the Federal Reserve charges on monetary loans to member banks.  A less commonly used (and less volatile) index is the average interest expense charged on all home mortgages.  This latter index is produced by the National Average Contract Interest Rate for Major Lenders on the Purchase of Previously Occupied Homes – quite a mouthful.  Both of these indices are noted in the Wall Street Journal, Monday real estate section.  The Federal Reserve Funds Index might be noted in your local paper as well.

Teaser rates of interest on ARMs

The analysis we went through earlier on properly analyzing and calculating our closing costs is equally applicable to both fixed rate mortgages and ARMS.  However, in our analysis of the ongoing cost and ongoing interest expense of the ARM, there is another very significant point that needs to be understood and analyzed.  As I have already pointed out, all things being equal, the Bank will charge less interest at the inception of an ARM than it will on a fixed rate mortgage.  Again, this is due to the fact that the Bank will not be locked into a below market interest rate on the ARM if market rates of interest increase in the future as it would on the fixed rate mortgage.  However, some ARM lenders provide an even lower "teaser rate" of interest in the first year or two of the ARM.  If you go the ARM route, you want to make sure that after a year or two a higher "fully-indexed" rate of interest doesn't pop the annual recomputed rate significantly higher than what you anticipated.

Example:  Mark and Debbie take out a $100,000 mortgage to finance the purchase of their home.  After careful analysis, Mark and Debbie decide to take out an ARM rather than a fixed rate mortgage.  The ARM is indexed to the Federal Reserve Funds Index.  At the inception of the loan, the Index is at a 5% rate.  One year from now, the interest rate will readjust to the Index rate plus 1½% points.  The initial year's rate of interest, however, is not set at 6½% (the 5% rate plus one and one-half a percentage point) but rather is set at 5%.  The Bank uses this extra-low first year rate to attract ARM customers.  One year from now, if the Index rate is still at 5%, Mark and Debbie will find that their second year of mortgage payments are readjusted using a 6½% rate of interest even though the underlying Index has not changed.

To avoid this problem you want to be fully aware of what the fully-indexed rate will be once the teaser rate falls off after a year or two.  These facts must be disclosed to you in writing and, if you ask, verbally.  But you must be aware of what a teaser rate of interest is versus a fully-indexed rate in order to be aware of the issue and ask the right questions.  Now you are!