Conventional mortgage loans are typically offered as fixed rates amortized over 30 or 15 years, for example, or as adjustable rate mortgages (A.R.M.s) which are most often amortized over 30 years. As the terms imply a fixed rate mortgage is fixed at a specific interest rate for the lifetime of the loan and an adjustable rate mortgage, well; adjusts. A fixed rate loan is most common amongst homeowners and is the most conservative approach to borrowing. That is, a long term loan at a fixed rate and therefore a completely predictable monthly payment. ARMS typically start at a lower rate and therefore a lower monthly payment than a fixed rate loan but at some point depending upon which type of ARM the rate changes according to a specific formula. Generally an ARM will create savings through the fixed period of the loan but its rate is then determined by the market and carries the risk of going higher thereby increasing monthly payments. It’s also possible that an ARM will go down in rate. The holder of such a note is taking the risk of playing a market.

Adjustable rate mortgages are tied to an index and a margin, together which determine the adjustment of the rate at the end of the fixed period and then, in most cases, annually thereafter through the lifetime of the loan. ARMs are fixed for various periods of time depending upon the type of ARM. In most cases the ARM with the shortest fixed period carries the lowest introductory rate. ARMs can be fixed for 6 months or a year but most ARM products are fixed for either 3, 5 or 7 years. In most cases a borrower opts for a 3/1, 5/1 or 7/1 ARM. In each case the first number refers to the period of time the rate is fixed at its start (or introductory) rate and the second number refers to how often the rate adjusts after that. So a 3/1 ARM is fixed for three years and then adjusts annually for the lifetime of the loan. The 5/1 and 7/1 behave the same but each is locked at its initial rate for 5 or 7 years respectfully.

The rules for each ARM vary slightly. For example, in most cases, a 3/1 ARM can adjust up or down no more than 2% on its initial adjustment (after 36 months), as well as on each subsequent adjustment. Typically the lifetime cap for the ARM is a total of 5%. A 5/1 and 7/1 behave similarly but in most cases can adjust up to 5% above start rate on the first adjustment (after 60 or 84 months respectively) and then no more than 2% each subsequent adjustment. In most cases these ARMs also have a lifetime cap of 5%.

The ARMs adjust according to a pre-determined index and margin. For example the index can be rates on one, three or five year treasury securities, the Cost of Funds Index (COFI) or most commonly in the mortgage world the London Interbank Offered Rate (LIBOR). This is the average rate that leading London Banks claim they are being charged when borrowing from other banks and is the index currently most often used with mortgage ARMs.. Each of these indices can be found weekly in the Wall Street Journal or online. In most all of the ARMs that mortgage brokers secure the index is the one year LIBOR and the margin is 2.25%. Therefore at the end of the 3, 5 or 7 year period the rate will adjust to whatever the LIBOR is plus 2.25% as it will each year thereafter confined by the annual caps described earlier. While the formula for adjusting rates is pre-determined there has often been controversy regarding conjecture that the LIBOR was being manipulated to benefit some banks and investors. This was part of the criminal charges against the Barclay Bank and other members banks in 2012. This is fodder for another column but for now the point is that while these indices appear to be mathematically fixed they are instead based, at least in part, by what banks report they are.

At the end of June 2014 the 1 year LIBOR rate was .55. A year ago at this time the rate was .68. If one had a 3/1 ARM that was set to adjust this month the rate would adjust to .55 plus 2.25% for a rate of 2.8%. This is significantly lower than current 30 year rates which are about 4.25% this month. Currently the start rate on a 3/1 ARM is about 3.125%. If your 3/1 ARM was adjusting this month your rate would drop to the 2.8%

The obvious question is should one take out a fixed mortgage or an ARM. The answer is, it depends. The analysis is dependent upon how long the borrower expects to keep the mortgage and how important a fixed rate is to one’s financial planning. If the borrower expects to sell the house or payoff the mortgage within 5 – 7 years then an ARM will most likely save the borrower a great deal of money. If instead one expects to keep the house more than 7 – 10 years and has no expectation of lowering the principal other than through monthly payments a fixed rate may feel more secure and would protect the borrower against any great increase in the LIBOR over time. Regardless when securing a mortgage either to purchase or refinance a home it makes sense to have this conversation with your broker or banker to determine what mortgage product best suits your needs.

Written by Ted Dimond