Not All Adjustable Rate Mortgages are Toxic

I have been receiving a of lot calls from past clients inquiring whether or not if now is the time to refinance. Many inquires concern an adjustable rate mortgage that has been fixed for the past five years and now is set to adjust. There is a misconception that all adjustable rate mortgages (ARMs) adjust to a much higher interest rate. This is not necessarily the case. There are many Intermediate fixed term ARMS that have very favorable terms at adjustment. The fact is all ARMs are not alike. The Press will headline Subprime ARMs that were given to borrowers a few years ago with credit, income and asset issues. These Subprime ARMs do contain new terms at adjustment that will insure the adjustment interest rate will be higher than the initial NOTE rate. The fact is not all ARMs are subprime there are Prime or “A” paper ARMs as well. There is a large spread between these two types of ARMs and if you have an ARM you need to understand what the terms of your loan are before making a decision to refinance.

Definition of an ARM

An ARM allows the lender the ability at a future date to adjust the interest rate and payment terms of a mortgage loan to the market based on two factors. The first factor is a published and market accepted interest rate Index; the index also has to be outside the control of the lien holder. The mortgage industry has accepted several Indexes to tie its various mortgage loan products. Here is a list of the most common residential mortgage indexes:

• CMT –These indexes are the weekly or monthly average yields on U.S. Treasury securities adjusted to constant maturities.
• MTA -- The Monthly Treasury Average, also known as 12-Month Moving Average Treasury index (MAT) is a relatively new ARM index. This index is the 12 month average the monthly average yields of U.S. Treasury securities adjusted to a constant maturity of one year. It is calculated by averaging the previous 12 monthly values of the 1-Year CMT.
• LIBOR -- London Inter Bank Offering Rate is an average of the interest rate on dollar-denominated deposits, also known as Eurodollars, traded between banks in London. The Eurodollar market is a major component of the International financial market. LIBOR is quoted as a one month, six month, and one year index.
• PRIME -- The Prime Rate is the interest rate charged by banks for short-term loans to their most creditworthy customers whose credit standing is so high that little risk to the lender is involved. This index is directly affected by the Federal Reserve interest rate policy. This index is widely used for Home Equity Lines of Credit and Second Mortgage loans.
  

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The index will raise or fall depending on the general credit market and each month a snapshot of the index is taken and used by mortgage lenders to determine a given loan’s interest rate. All the above indexes are an indication of the short term interest rate environment – debt that is repaid within a one year time frame or shorter. There are longer term indexes but for our discussion most residential mortgage ARMs are based on one of the above Indexes.

The second factor to an ARM is the Margin. This is the fixed percentage that will be added to the Index at adjustment to determine the new interest rate. Margins vary widely between Subprime and “A” paper loans for example:

On a Subprime loan the margin might equal the start rate / initial interest of the Note taken at closing. If the interest rate was initially 7% for the first three years of the loan the margin might also equal 7%. Therefore the interest rate will always be at least 7%, but only if the corresponding index were to go to zero. That would mean a zero interest rate environment, not likely, so this borrower will be looking at an increase at adjustment. An “A” paper loan will typically carry a margin less than 3% and has no relation to the starting Note rate. Therefore at adjustment the “A” paper loan could very well adjust lower depending on the current interest rate environment. The two components to all ARMS are the index, this will change over time, and the Margin a fixed percentage added to the index to determine the new interest rate.

In addition to the two elementary components Index and Margin there are two other concepts that need to be understood by the borrower. These are the interest rate caps and adjustment term. Interest rate caps are contractual and defined in the mortgage Note at closing. These caps will contain or keep interest rates from adjusting above or below a defined level. For example the interest rate caps might be expressed as 5/2/5. This means that the interest rate cannot adjust more than 5% at the fist adjustment, no more than 2% at each subsequent adjustment and never adjust more than 5% over the loan’s lifetime. 5/2/5 are typical caps on “A” paper 5, 7 and 10 year fixed ARMs, but you might also see 2/2/6. How it works is if the index used for the mortgage raises enough so that the new interest is above 5% the initial start rate, then the lender will be able to adjust the new rate to that level. This way the lender is able to receive interest comparable to the current market interest rates. Further if the loan were to adjust the full 5% at the first adjustment it could never be higher than this amount for the life of loan. The second cap, in this case 2%, comes into play when index has increased or decreased less than the 5% during the initial fixed term. Therefore the loan would adjust to the new interest rate index plus margin for the new fixed period of time. At each subsequent adjustment the interest rate can only increase a maximum of 2% until and if it reaches the maximum of 5%. The period of time the loan’s interest rate is fixed once more at each subsequent adjustment is the adjustment term. This is generally based on the index chosen for the mortgage product. For example if the lender uses the CMT or 1-Year LIBOR index, then the loan will adjust annually after the initial fixed term of the Note. If a 6-month LIBOR is used, then the loan will adjust every six months. If the MTA is used, then the loan will adjust monthly for the remaining term of the loan and so on.

Examples:

An “A” paper mortgage ARM; initial interest rate 4.75% for the first five years, then adjusting each twelve month period thereafter for the balance of the twenty five year term; most ARMS are based on a 30 year Amortization. The Margin is 2.75% and the index used is the 1 year LIBOR with 5/2/5 caps. If this loan was closed in October of 2003 the October 1-Year LIBOR index was 1.5625%. I want to bring to your attention the fully index rate (Margin plus Index) at the initial closing. In 2003 the fully indexed rate was 4.375% rounded to the nearest eighth (1.5625% plus 2.75%). As you can see the initial Note rate was .375% higher than the index plus the margin. In October of 2008 this loan will adjust based on the terms of the Note. However the lien holder cannot wait till the October’s index is published to adjust the interest rate. Therefore the terms of Note will generally allow for 45 days prior to adjustment the then index will be used and a notice of the new interest rate will be sent to the borrower. In our case that would mean before August 15th 2008 the August 1-year LIBOR index will be used to by the lender. The 2008 August 1 Year LIBOR index is 3.244%. Therefore in this example the new interest rate will be 6.00% rounded to the nearest eighth (3.244% plus 2.75%) and a letter explaining this change would be mailed to the borrower. That is a 1.25% increase and is much lower than current fixed ate interest rates that stand around 6.75%.

Let’s use the same example but change two of the components. Lowering the margin to 2.25% and switching the Index to the 1 Year CMT. The October CMT was 1.25% plus our margin would have equaled the fully indexed rate of 3.50%. In this case the initial Note rate was 1.25% higher than the initial fully index rate. Fast forward five years the August CMT is 2.12% plus our margin will equal a new interest rate of 4.375% (2.12% plus 2.25%)—that would be a .375% decline in rate. In this example you can see the difference in which index is used as well as the margin. There can be a significant difference between ARMs depending on the initial structure.

One caveat, the CMT was used widely a few years ago but today most ARMs are based on the 1-Year LIBOR.

If we consider the caps in both cases the first adjustment cap would not come into play because the index did not raise enough for the adjustment to climb 5% above the initial start rate of 4.75%. The Note’ index with 2.75 Margin would have to climb to 7% and the Note’s index with the 2.25 Margin would have to have climbed to 7.5%. Historically over the past 18 years the CMT highest point was 7.78% in August 1990 and went to 7.14% in December of 1994. The 1 Year LIBOR has been .25% to 1% higher in any corresponding month than the CMT.

This doesn’t mean the CMT is superior to the 1 Year LIBOR it just means you need to understand the terms of your mortgage Note and how these affect the interest adjustment.

In my examples there are clear differences between Subprime and “A’ paper ARMs. The fact is Subprime ARMs might be considered toxic; this set of borrowers has been excluded from being able to refinance these ARMs because of the illiquidity of the current mortgage market. For many Subprime borrowers the only way to refinance is with an FHA insured mortgage or asking the current lien holder to restructure the terms of the mortgage note. However the “A” paper borrower should not confuse their situation with that of a Subprime borrower nor ignore the benefits of intermediate fixed ARMs. In fact if one is purchasing a home today and needs a Jumbo loan (a loan amount above $523,750 – jumbo conforming limit for most counties inside the 128 belt of Massachusetts), then your only choice may be a five or seven year fixed ARM. Many of the available Jumbo ARMs have favorable terms and should be considered as part of the mortgage planning process.

If you are considering refinancing, have your Note reviewed by a mortgage planning professional. This will help you understand where the loan might adjust so that you can make a comparison to the current interest rate environment; you might be pleasantly surprised. As part of my planning process for my clients we perform an annual review and an ongoing review with a mortgage under management process. To learn more on whether you should refinance contact me and I will perform a review of your current mortgage and make recommendations based on your future goals as well as interest rates.