Adjustable-rate mortgage

A variable-rate mortgage, adjustable-rate mortgage (ARM), or tracker mortgage is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets. The loan may be offered at the lender's standard variable rate/base rate. There may be a direct and legally defined link to the underlying index, but where the lender offers no specific link to the underlying market or index, the rate can be changed at the lender's discretion. The term "variable-rate mortgage" is most common outside the United States, whilst in the United States, "adjustable-rate mortgage" is most common, and implies a mortgage regulated by the Federal government, with caps on charges. In many countries, adjustable rate mortgages are the norm, and in such places, may simply be referred to as mortgages.

Among the most common indices are the rates on 1-year constant-maturity Treasury (CMT) securities, the cost of funds index (COFI), and the London Interbank Offered Rate (LIBOR). A few lenders use their own cost of funds as an index, rather than using other indices. This is done to ensure a steady margin for the lender, whose own cost of funding will usually be related to the index. Consequently, payments made by the borrower may change over time with the changing interest rate (alternatively, the term of the loan may change). This is distinct from the graduated payment mortgage, which offers changing payment amounts but a fixed interest rate. Other forms of mortgage loan include the interest-only mortgage, the fixed-rate mortgage, the negative amortization mortgage, and the balloon payment mortgage.

Adjustable rates transfer part of the interest rate risk from the lender to the borrower. They can be used where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate falls but loses if the interest rate increases. The borrower also benefits from reduced margins to the underlying cost of borrowing compared to fixed or capped rate mortgages.

In contrast to fixed-rate mortgages, adjustable-rate mortgages are unaffected by inflation risk, but they are exposed to the risk that real interest rates will change. Adjustable-rate mortgages usually charge lower interest rates than those with fixed rates. According to scholars, "borrowers should generally prefer adjustable-rate over fixed-rate mortgages, unless interest rates are low."

Characteristics

Index

11th District Cost of Funds Index (COFI)
London Interbank Offered Rate (LIBOR)
12-month Treasury Average Index (MTA)
Constant Maturity Treasury (CMT)
National Average Contract Mortgage Rate
Bank Bill Swap Rate (BBSW)
Consumer Price Index (CPI)

In some countries, banks may publish a prime lending rate which is used as the index. The index may be applied in one of three ways: directly, on a rate plus margin basis, or based on index movement.

A directly applied index means that the interest rate changes exactly with the index. In other words, the interest rate on the note exactly equals the index. Of the above indices, only the contract rate index is applied directly.

Initial interest rate. This is the beginning interest rate on an ARM.
The adjustment period. This is the length of time that the interest rate or loan period on an ARM is scheduled to remain unchanged. The rate is reset at the end of this period, and the monthly loan payment is recalculated.
The index rate. Most lenders tie ARM interest rates changes to changes in an index rate. Lenders base ARM rates on a variety of indices, the most common being rates on one-, three-, or five-year Treasury securities. Another common index is the national or regional average cost of funds to savings and loan associations.
The margin. This is the percentage points that lenders add to the index rate to determine the ARM's interest rate.
Interest rate caps. These are the limits on how much the interest rate or the monthly payment can be changed at the end of each adjustment period or over the life of the loan.
Initial discounts. These are interest rate concessions, often used as promotional aids, offered the first year or more of a loan. They reduce the interest rate below the prevailing rate (the index plus the margin).
Negative amortization. This means the mortgage balance is increasing. This occurs whenever the monthly mortgage payments are not large enough to pay all the interest due on the mortgage. This may be caused when the payment cap contained in the ARM is low enough such that the principal plus interest payment is greater than the payment cap.
Conversion. The agreement with the lender may have a clause that allows the buyer to convert the ARM to a fixed-rate mortgage at designated times.
Prepayment. Some agreements may require the buyer to pay special fees or penalties if the ARM is paid off early. Prepayment terms are sometimes negotiable.

The choice of a home mortgage loan is complicated and time consuming. As a help to the buyer, the Federal Reserve Board and the Federal Home Loan Bank Board have prepared a mortgage checklist.

Caps

Any mortgage where payments made by the borrower may increase over time brings with it the risk of financial hardship to the borrower. To limit this risk, limitations on charges—known as caps in the industry—are a common feature of adjustable rate mortgages.

The popularity of hybrid ARMs significantly increased early in the 21st century. In 1998, the percentage of hybrids relative to 30-year fixed-rate mortgages was less than 2%; within six years, this increased to 27.5%.

These types of loans are also called "pick-a-payment" or "pay-option" ARMs.

When a borrower makes a Pay-Option ARM payment that is less than the accruing interest, there is "negative amortization", which means that the unpaid portion of the accruing interest is added to the outstanding principal balance. For example, if the borrower makes a minimum payment of $1,000 and the ARM has accrued monthly interest of $1,500, $500 will be added to the borrower's loan balance. Moreover, the next month's interest-only payment will be calculated using the new, higher principal balance.

Option ARMs are often offered with a very low teaser rate (often as low as 1%) which translates into very low minimum payments for the first year of the ARM. During boom times, lenders often underwrite borrowers based on mortgage payments that are below the fully amortizing payment level. This enables borrowers to qualify for a much larger loan (i.e., take on more debt) than would otherwise be possible. When evaluating an Option ARM, prudent borrowers will not focus on the teaser rate or initial payment level, but will consider the characteristics of the index, the size of the "mortgage margin" that is added to the index value, and the other terms of the ARM. Specifically, they need to consider the possibilities that (1) long-term interest rates go up; (2) their home may not appreciate or may even lose value or even (3) that both risks may materialize.

Option ARMs are best suited to sophisticated borrowers with growing incomes, particularly if their incomes fluctuate seasonally and they need the payment flexibility that such an ARM may provide. Sophisticated borrowers will carefully manage the level of negative amortization that they allow to accrue.

In this way, a borrower can control the main risk of an Option ARM, which is "payment shock", when the negative amortization and other features of this product can trigger substantial payment increases in short periods of time.

The minimum payment on an Option ARM can jump dramatically if its unpaid principal balance hits the maximum limit on negative amortization (typically 110% to 125% of the original loan amount). If that happens, the next minimum monthly payment will be at a level that would fully amortize the ARM over its remaining term. In addition, Option ARMs typically have automatic "recast" dates (often every fifth year) when the payment is adjusted to get the ARM back on pace to amortize the ARM in full over its remaining term.

For example, a $200,000 ARM with a 110% "neg am" cap will typically adjust to a fully amortizing payment, based on the current fully indexed interest rate and the remaining term of the loan, if negative amortization causes the loan balance to exceed $220,000. For a 125% recast, this will happen if the loan balance reaches $250,000.

Any loan that is allowed to generate negative amortization means that the borrower is reducing his equity in his home, which increases the chance that he won't be able to sell it for enough to repay the loan. Declining property values would exacerbate this risk.

Option ARMs may also be available as "hybrids", with longer fixed-rate periods. These products would not be likely to have low teaser rates. As a result, such ARMs mitigate the possibility of negative amortization, and would likely not appeal to borrowers seeking an "affordability" product.

Cash flow ARMs

A cash flow ARM is a minimum payment option mortgage loan. This type of loan allows a borrower to choose their monthly payment from several options. These payment options usually include the option to pay at the 30-year level, 15-year level, interest only level, and a minimum payment level. The minimum payment level is usually lower than the interest only payment. This type of loan can result in negative amortization. The option to make a minimum payment is usually available only for the first several years of the loan.

Cash flow ARM mortgages are synonymous with option ARM or payment option ARM mortgages, however not all loans with cash flow options are adjustable. In fact, fixed rate cash flow option loans retain the same cash flow options as cash flow ARMs and option ARMs, but remain fixed for up to 30 years.

{| class="wikitable"

|+Terminology

!Term

!Definition

|X/Y

|Hybrid ARMs are often referred to in this format, where X is the number of years during which the initial interest rate applies prior to first adjustment (common terms are 3, 5, 7, and 10 years), and Y is the interval between adjustments (common terms are 1 for one year and 6 for six months). As an example, a 5/1 ARM means that the initial interest rate applies for five years (or 60 months, in terms of payments), after which the interest rate is adjusted annually. (Adjustments for escrow accounts, however, do not follow the 5/1 schedule; these are done annually.)

|Fully Indexed Rate

|The price of the ARM is calculated by adding Index + Margin = Fully Indexed Rate. This is the interest rate your loan would be at without a Start Rate (the introductory special rate for the initial fixed period). This means the loan would be higher if adjusting, typically, 1–3% higher than the fixed rate. Calculating this is important for ARM buyers, since it helps predict the future interest rate of the loan.

|Margin

|For ARMs where the index is applied to the interest rate of the note on an "index plus margin" basis, the margin is the difference between the note rate and the index on which the note rate is based expressed in percentage terms. Ireland and Canada but are unpopular in some other countries such as Germany. So far, it is the only bank in Singapore to offer such a mortgage.

Pricing

Adjustable rate mortgages are typically, but not always, less expensive than fixed-rate mortgages. Due to the inherent interest rate risk, long-term fixed rates will tend to be higher than short-term rates (which are the basis for variable-rate loans and mortgages). The difference in interest rates between short and long-term loans is known as the yield curve, which generally slopes upward (longer terms are more expensive). The opposite circumstance is known as an inverted yield curve and is relatively infrequent.

The fact that an adjustable rate mortgage has a lower starting interest rate does not indicate what the future cost of borrowing will be (when rates change). If rates rise, the cost will be higher; if rates go down, cost will be lower. In effect, the borrower has agreed to take the interest rate risk.

The actual pricing and rate analysis of adjustable rate mortgage in the finance industry is done through various computer simulation methodologies like Monte Carlo method or Sobol sequences. In these techniques, by using an assumed probability distribution of future interest rates, numerous (10,000–100,000 or even 1,000,000) possible interest rate scenarios are explored, mortgage cash flows calculated under each, and aggregate parameters like fair value and effective interest rate over the life of the mortgage are estimated. Having these at hand, lending analysts determine whether offering a particular mortgage would be profitable, and if it would represent tolerable risk to the bank.

Prepayment

Adjustable rate mortgages, like other types of mortgage, usually allow the borrower to prepay principal (or capital) early without penalty. Early payments of part of the principal will reduce the total cost of the loan (total interest paid), but will not shorten the amount of time needed to pay off the loan like other loan types. Upon each recasting, the new fully indexed interest rate is applied to the remaining principal to end within the remaining term schedule.

If a mortgage is refinanced, the borrower simultaneously takes out a new mortgage and pays off the old mortgage; the latter counts as a prepayment.

Some ARMs charge prepayment penalties of several thousand dollars if the borrower refinances the loan or pays it off early, especially within the first three or five years of the loan.[http://www.federalreserve.gov/pubs/arms/arms_english.htm]

Criticism

Predatory lending

Adjustable rate mortgages are sometimes sold to consumers who are unlikely to repay the loan should interest rates rise. In the United States, extreme cases are characterized by the Consumer Federation of America as predatory loans. Protections against interest rate rises include (a) a possible initial period with a fixed rate (which gives the borrower a chance to increase his/her annual earnings before payments rise); (b) a maximum (cap) that interest rates can rise in any year (if there is a cap, it must be specified in the loan document); and (c) a maximum (cap) that interest rates can rise over the life of the mortgage (this also must be specified in the loan document).

Interest rate errors and overcharges

In September 1991, the Government Accountability Office (GAO) released a study of Adjustable Rate Mortgages in the United States which found between 20% and 25% of the ARM loans out of the estimated 12 million at the time contained Interest Rate Errors. A former federal mortgage banking auditor estimated these mistakes created at least US$10 billion in net overcharges to American home-owners. Such errors occurred when the related mortgage servicer selected the incorrect index date, used an incorrect margin, or ignored interest rate change caps.

In July 1994, Consumer Loan Advocates, a non-profit mortgage auditing firm announced that as many as 18% of Adjustable Rate Mortgages have errors costing the borrower more than $5,000 in interest overcharges.

In December 1995, a government study concluded that 50–60% of all Adjustable Rate Mortgages in the United States contain an error regarding the variable interest rate charged to the homeowner. The study estimated the total amount of interest overcharged to borrowers was in excess of $8 billion. Inadequate computer programs, incorrect completion of documents and calculation errors were cited as the major causes of interest rate overcharges. No other government studies have been conducted into ARM interest overcharges.

Ireland’s Tracker Mortgage Scandal

In 2015, Ireland’s Central Bank recognised that the country had a problem with banks moving customers away from low interest, and unprofitable, tracker mortgages in an adverse manner, and setup an investigation into what had happened.

History

On April 3, 1980, the Federal Home Loan Bank Board voted to authorize savings and loan associations to offer the renegotiable-rate mortgage (RRM) to mortgagors for home purchases, the first variable rate mortgage in the United States. Under the regulations, the interest rate could be changed every three years, and could rise no more than 5 percentage points over the original APR life of a 30-year mortgage, or be lowered without limit. The new rule was made in response to a decrease in new housing starts and purchases by buyers hesitant about a long-term commitment to the high interest rates at the time, and was a concept similar to the "rollover mortgage" that were already in use in Canada.

TITLE VIII, ALTERNATIVE MORTGAGE TRANSACTIONS, Garn–St. Germain Depository Institutions Act of 1982 allowed Adjustable rate mortgages.

In 2006, before the subprime mortgage crisis, over 90% of the subprime mortgages (which accounted for 20% of all mortgages) were adjustable-rate mortgages.

References

External links

U.S. Federal Reserve Consumer Handbook on Adjustable Rate Mortgages
US historical ARM index rates
US historical mortgage rates, 1982 – present
Daily Adjustable Mortgage Rate Survey by Mortgage News Daily
US historical ARM index rates