How do adjustable-rate mortgages work?

Question of the week:  How do adjustable-rate mortgages work?

Answer: With rates for 30- and 15- year mortgages at their highest sustained levels in over a decade many home buyers and homeowners are considering adjustable-rate mortgages; as well many borrowers with circumstances that preclude them from qualifying for conventional mortgages.

Adjustable-rate mortgages (ARMs) all have in common how the rate is determined. What they do not have in common is when the mortgage rate will adjust.

Rates for ARMs are determined by having an index and a margin.

The index is a rate that is publicly known and reflects current interest rates in the economy. The most common rates used for ARMs are based on U.S. Treasury bills and notes.

The margin is a fixed amount that is added to the index to determine what your interest rate will be, the most common margin is 2.5%.

For instance, if the index is the currently 1.00% and the margin is 2.5% the rate would be 3.5%. This is known as the “fully indexed rate.”

That sounds great with today’s fixed rates in the 5% range. However….

Very few ARM programs start at the fully indexed rate, usually they start above the fully indexed rate. As well, ARM programs have floors and ceilings, or caps, for the rate the borrower may pay.

Not only is there a ceiling on how high the rate can go over the life of the mortgage, there is usually a limit on how high the rate can climb or drop from one adjustment to the next*.

For instance, we may see an ARM program with 2/5 limits. This means the rate cannot increase or decrease more than a 2% adjustment*, or more than 5% over the initial rate for the ARM for the life of the loan.

The most common ARMs for the past several years have been “hybrid-ARMs.” The are loans that have a period where the initial rate is fixed for a number of years and then the rate begins to adjust annually. These ARMs are seen as 3/1, 5/1, 7/1, 10/1 programs. The first number is the number of years the rate is fixed, the second number is how often the rate will adjust after the loan converts from fixed rate to adjustable.

*For hybrid ARMs, the first adjustment after the fixed rate period can increase to the maximum for the life of the loan, after that the annual limit will be in place. For instance, you obtained a 7/1 ARM with 2/5 limits with an initial rate of 3.5%. After the 84th month the mortgage is transitioning from fixed to adjustable rate. The index plus margin totals 8.00%, since this is the first adjustment for the loan, and the increase limit is 5% over the start rate, your new rate for the coming year will be 8.00%.

Staying with this loan example. The next year the index used for your mortgage drops considerably, and the index plus the margin totals 5.25%. Because the annual rate adjustment limit is 2%, your rate will drop from 8.00% to 6.00%.

The obvious risk for ARMs is what will your rate and payment be when in the future. For hybrid ARMs your payment is fixed for the initial period and based on a 30-year amortization**. Once the mortgage converts to the adjustable period, the payment is based on the rate amortized over the remaining term of the loan. For instance, you funded a $500,000 5/1 ARM with an initial rate of 4.00% and a payment of $2387 per month. After the fifth year the balance is $452,200 and your rate adjusts to 6.00%, your new loan payment will be based on the loan balance, your new rate, amortized for 25 years remaining for a payment of $2914 per month.

**Some ARMs have a period where the minimum required payment is interest only.

There are benefits, and risks, with ARMs, before making a decision to obtain an ARM it is important to understand the risks to you in terms of potential payments in the future.

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Data supports continued rate hikes. The monthly Labor Department job numbers showed that hiring continued to be strong in May. The economy added 390,000 jobs for the month. While this is the smallest number of jobs added in the past 13-months, that could be because the economy has recovered most of the jobs lost during the pandemic. Leisure and Hospitality jobs led the increase, accounting for over 20% of the job gains. On the other side, retailers continue to shed workers, losing 61,000 in May. Wages continue to increase, though at a slower rate, growing 5.2% from May 2021, down from the year-to-year increase in April of 5.5%. The news is mortgage rate unfriendly as the Fed is, rightfully, concerned that continuing strong labor market numbers, with accompanying higher wages, will not create an environment for inflation to cool off. The data supports last week’s news that the Fed is like to push its bench mark rate higher by 0.500% at its next two meetings.

Rates for Friday June 3, 2022: After three weeks in a row with rates dropping Friday-to-Friday, we reverse the trend with rates bouncing back up.

FIXED RATE MORTGAGES AT COST OF 1.25 POINTS LOCKED FOR 45 DAYS FOR PURCHASE TRANSACTIONS:

30-year conforming                                        4.875%                Up 0.125%

30-year high-balance conforming                   5.50%               Down 0.125%

Please note that these are base rates and adjustments may be added for condominiums, refinances, credit scores, loan to value, no impound account and period rate is locked. Rates are based on 20% down with 740 FICO score for purchase mortgages.

Our dog’s tail may fall off tonight from wagging too hard. Leslie comes home after being away since we left for our daughter’s graduation on May 18th. Our dog loves her very, very, very, much and has been semi-mopey since I returned last Monday and brought him home from his doggy-hotel.

My tail may fall off as well, having not seen her since last Monday when I left Boston for home. The next day, Leslie and our daughter flew to Paris for a trip that was postponed from April 2020 when our daughter was in school in Grenoble, France, and they were to meet in Paris for her spring break.

The two boys in the house, Sammy and myself, are very excited to have Leslie back home, making all right in our worlds.

Have a great week,

Dennis

Past Weekly Rate & Market Updates can be found on my blog page at my website www.DennisCSmith.com/my-blog