With higher mortgage rates comes talk of adjustable-rate mortgages (ARMs). Orion’s brokers know that, as with any loan program, there are pros and cons and the uncertainty of the ARM’s interest rate in the future compared to a fixed rate mortgage is a great concern to many. But at this point there is growing talk about how mortgage rates have reached their peak, and rates may head down, so now is a very good time to consider an ARM for your client’s home purchase, and possibly refinance.
Brokers know that interest rates change all of the time. But to give you an idea of numbers,today a $800,000 purchase with 20 percent down and a 760 FICO score, the rate on a 30-year fixed rate mortgage is 7.625 percent, with a payment of $4530 per month. The rate for the same transaction with a 5/6 ARM is 7.25 percent with a payment of $4365 per month, for a payment differential of $165 per month, or almost $2000 per year. For high-balance loans the 5/6 ARM rate might be 7.25 percent, the fixed rate is 8.00 percent, on a loan of $800,000 the difference in monthly payment is $413 per month, or almost $5000 per year.
Orion’s clients know that most ARMs are “intermediate” adjustable mortgages that are fixed for a certain period of time and then adjust after that. A 5/1 ARM has a fixed interest rate for the first five years and then switches to an adjustable interest rate for the remainder of its term once a year, with a 5/6 adjusting every six months; A 3/1 ARM is fixed for three years, a 7/1 is fixed for seven. An ARM has a fixed rate for the first several years of the loan term that’s often called the “teaser rate” because it’s lower than any comparable rate you can get for a fixed-rate mortgage. Rates may be fixed for 7 or 10 years, although the 5-year ARM is a very common option.
Once the fixed-rate portion of the term is over for your client, the ARM adjusts up or down based on current market rates of its index, subject to caps governing how much the rate can go up in any particular adjustment. Typically, the adjustment happens once per year or once every six months and the new rate is calculated by adding an index number to a margin specified in your client’s mortgage documentation. Common indexes used for ARMs, once they adjust, include the Secured Overnight Financing Rate (SOFR), the Cost of Funds Index (COFI) and the Constant Maturity Treasuries (CMT). And each time your client’s interest rate changes, their payment is recalculated so that the loan is paid off by the end of the term.
An ARM may have “5/2/5 caps.” What does that mean? A 5/1 ARM with a 5/2/5 cap structure means that for the first seven years the rate is unchanged, but on the eighth year your client’s rate can increase by a maximum of 5 percentage points (the first "5") above the initial interest rate. Every year there after, the rate can adjust a maximum of 2 percentage points (the second number, "2"), but the interest rate can never increase more than 5 percentage points (the last number, "5") over the life of the loan. Other than the margin in your client’s loan documentation, there’s no limiting factor tohow much the interest rate could adjust down in any particular year if interest rates have moved lower.
Because the interest rate can change in the future, an ARM is structured so that your client can get a lower interest rate for the first several years of the loan than they would if your client were to go with a comparable fixed rate. If your client knows that they’re in a starter home and will be moving in a few years,your client might move before the interest rate ever adjusts.
A 5/6 ARM has a fixed rate for the first five years of the loan and then adjusts every six months. The most the rate can change, up or down at the first adjustment is 2 percent, thereafter the cap and floor each adjustment is 1 percent. The maximum the rate can increase is 5 percent above the start rate. For the above examples with 7.25 percent, the most the rate can increase is to 12.25 percent.
That is the primary risk for an ARM, if rates increase so when your client enters the adjustable period they may see their rate increase. On the other hand, if rates drop your client will see their rate go down.
For the majority of ARM programs, the qualifying rate (used by underwriters to make sure a borrower has the ability repay the loan) is the greater of the note rate (start rate) + 2 percent, or the fully adjusted rate today. An ARM may be the right loan for your client, call an Orion AE to run the numbers on your client’s qualifying ability using an ARM to see if it is.