What is an ARM? A mortgage with a fixed rate for a specific period of time, then the rate adjusts.
• May have a lower rate.
• May be able to use the lower rate to qualify for more home.
• Take advantage of falling rates without refinancing
• May help homeowners save and invest more.
• More complicated than a fixed rate option.
• Payments can increase, after the fixed period.
• May create risk. If the rate increases and the homeowner’s unable to refinance or sell, it may lead to an unsustainable situation.
Who’s a good fit for an ARM? An ARM can be a very good solution, for the right homeowner in the right interest rate environment. They don’t always offer enough benefit to justify giving up the security of a fixed rate mortgage, however are worth considering for the right homeowner. This may include:
• A homeowner who doesn’t plan to stay in their home long-term.
• A homeowner who doesn’t plan to have their mortgage long-term.
• A homeowner who’s comfortable with a more dynamic mortgage.
• A homeowner who doesn’t have concern their employment/income will change, disallowing them to refinance out of the mortgage.
When will ARMs make sense? ARMs make the most sense when short term financing is considerably less expensive then long term financing.
How does the yield curve affect ARMs? To quickly understand the rate environment, and if an ARM is worthwhile you can quickly compare two indicators -> Short term (2-year US Treasury) vs long term (10-year US Treasury). The wider the gap between the two, the more advantageous ARM pricing will be. However the inverse is true as well, a narrow gap results in a more advantageous environment for fixed rate loans.
As the Fed manipulates the market, they directly impact this comparison/yield curve. By raising and lowering the Fed Funds Rate, they’re directly affecting short-term lending, making ARMs more/less advantageous.
**A good website to see the difference in 10yr vs 2yr Treasuries: https://fred.stlouisfed.org/series/T10Y2Y
For the yield curve to steepen (bigger difference between ARM vs Fixed pricing), one of two things would need to happen:
1. Short term rates drop – not going to happen in the short term with the Fed raising rates
2. Long term rates have to increase substantially – not ideal, will make it harder for buyers to qualify with 30yr fixed loans.
At the moment:
5yr & 7yr ARMs pricing is better than a 30yr fixed, however only slightly. 30yr fixed pricing is better than 10yr ARM pricing.
SOFR vs Libor
SOFR is the index used to derive ARM pricing. It stands for secured overnight financing rate. Fannie Mae uses a 30-day average of the SOFR index as published by the Fed Reserve. Libor was previously used, however was subject to manipulation.
4 ARM components
-interest rate cap
-initial interest rate period
**When the initial fixed period has expired, the new rate is calculated by adding the margin to the index
5/6 – fixed for the first 5 years, then adjust every 6 months.
7/6 – fixed for the first 7 years, then adjust every 6 months.
10/6 – fixed for the first 7 years, then adjust every 6 months.
First interest rate change
5/6 – 60 months from the first payment date
7/6 – 84 months from the first payment date
10/6 – 120 months from the first payment date
Rate adjustment caps
5/6 – first adjustment may change the previous rate by no more than 2%
7/6 or 10/6 – first adjustment may change the previous rate by no more than 5%
Subsequent adjustment cap: each subsequent adjustment may change the previous rate by no more than 1%, up or down.
Lifetime adjustment cap: 5% over the initial note rate.
ARM to Fixed conversion option: Not permitted
Assumability: Assumable during the adjustable-rate period, by qualified borrowers.
-Fannie – note rate + first rate change cap
-Freddie – note rate + 2%
ARMs > 5yr initial fixed-rate period – note rate