Adjustable Rate Mortgages
David "The Solution" Murray - August 1, 2022
Fixed rate Mortgage Loans have been the dominant choice of borrowers for many years. After all, mortgage rates of been historically low over the past several years. For example, in 2005 ARM’s (Adjustable Rate Mortgages) accounted for roughly 34% of total originations. So far in 2022, ARM’s have accounted for roughly 5% of total originations. Borrowers tend to shy away from the risk that their interest rate might go up over the life of their loan. In today’s blog post we discuss how an ARM works and the simple calculation that applies to any type of ARM loan:
Regardless of the type of ARM program you select the simple calculation all lenders use to determine subsequent interest rates in the future years of your loan is this: INDEX + MARGIN NOT TO EXCEED CAPS. Let’s define Index, Margin, and Caps.
Index: ARM index is the benchmark rate that’s connected to an adjustable rate mortgage. This is a variable rate that can increase or decrease over the life of the loan. The Fannie Mae index used today is the SOFR (Secured Overnight Financing Rate). These indexes and their current rates are widely published and can be found using a simple Google search.
Margin: ARM margin represents the number of percentage points that an interest rate on an adjustable rate mortgage can increase once the fixed-rate period ends. Lenders have some flexibility as to the amount of margin they use. Typical margins range from 2.25% to 3.00%.
Caps: Arm Caps represent the maximum adjustment to the rate at certain times over the course of the loan. Initial rate adjustment cap, subsequent rate adjustment caps, and lifetime rate adjustment caps. The Initial Rate Adjustment is the first adjustment after the fixed period ends. Subsequent Adjustments are the maximum semi-annual or annual adjustments. Lifetime adjustments are the maximum the rate can increase. As an example if the program you select is a 5/6 SOFR ARM product your Caps would be 2/1/5 meaning the Initial Cap is 2.00%, Subsequent Caps 1.00%, and Lifetime Caps would be 5.00%. Now let’s apply our simple ARM adjustment calculation:
INDEX + PLUS MARGIN NOT TO EXCEED CAPS: (Rates are used as an example only)
5/6 SOFR ARM (Fixed Rate for 5 years (60 months) and adjusts every 6 months thereafter)
1.550% (SOFR Index is variable and changes daily)
2.500% (Margin is fixed for the life of the loan)
2/1/5 (Caps are fixed for the life of the loan)
Simple Calculation: Index 3.25% + Margin 2.500% not to exceed cap of 2.00% = New Rate of 5.75%. 5.75% would be the interest rate on the remaining balance of the loan for the 6 months following the initial adjustment. The maximum interest rate for the life of the loan would be 9.500% using our example above.
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