Do you have an Adjustable Rate Mortgage?

Over the last several years many people chose an Adjustable Rate Mortgage (ARM) for financing their home. Most ARMs fall into one of three categories. An ARM in its simplest form is a mortgage that is open to a rate change every 1, 3 or 5 years. In this scenario the borrower elects to pay a lower interest rate on his mortgage in exchange for taking on the liability of future interest rate movements.

In a fixed rate mortgage the lender commits to an interest rate for the entire term of the mortgage. The lender charges an interest rate that is high enough to cover any increase in their costs of funds during the mortgage’s term. When a borrower elects to use an ARM he agrees to give the lender a guaranteed profit over their costs of funds. If rates go up, the borrower pays more. If rates go down then the borrower pays less.

The second type of ARM is a hybrid adjustable. Here there is an initial term of 3, 5, 7 or 10 years where the rate remains the same. At the end of this initial period the mortgage becomes a 1-year ARM. At this point the rate will change every year as the financial markets move.

Finally, there is the pay option ARM. Under this program in addition to the rate changing periodically the borrower has the option of selecting, with certain limitations, the dollar amount the payment should be for a particular month. The borrower can elect to pay as much principal he wants, pay no principal just the interest due for the month or pay less than the interest charge for the month effectively borrowing additional money.

Due to all the negative press directed at the subprime mortgage market and their ARM programs everyone that currently has an ARM is panicking. We are warned about the number of hybrid ARMS that are resetting this year or will reset in the next year or two. This is encouraging anyone who currently has an ARM to immediately refinance into a fixed rate mortgage regardless of the cost or their personal financial situation.

If you are in an ARM you need to understand the details of your mortgage before doing anything else. You could very easily be in the proper mortgage and not even realize it. Refinancing may be an expense that you don’t need to incur right now.

One thing that all ARMs have in common is that there is a formula that specifies what the rate will become at a rate change. Another common attribute of all ARMS is that there are limitations (caps and floors) that dictate the range you mortgage can rest to each time it adjusts. Before doing anything you need to find these details.

At your closing you signed numerous papers and you were given a copy of everything you signed. Hopefully you kept those papers. Go back and look for a document labeled “Note”. The 2 most important documents you signed are the “Mortgage” and the “Note”.

The mortgage is the actual lien that is filed against the property. There are no details in this document regarding interest rate, mortgage payment, term etc. All that information is contained in the “Note”. The “Note” specifics the details of how you have agreed to pay back the money you borrowed from the lender. It’s here that you will find the formula used in calculating your interest rate and the limits of the change.

You can’t find those papers. Now what do you do? The servicer, that is the company you make out your mortgage payment to each month, has a copy of the “Note” in their files. Many even provide access to your closing documents through their website. The servicer will supply you with a copy of the “Note”; all you need to do is request it.

The formula to calculate you new interest rate will consist of an index rate and a margin that are added together and give you your new interest rate. The index rate is a rate reflects market conditions, it is an interest rate that the lender doesn’t have influence over.

Typically it will be the yield on 1-year Treasury Bills or on the 1-year LIBOR. The 1-year T-Bill is the current rate the US government needs to pay an investor to borrow money for 1 year. LIBOR (the London Inter-Bank Offer Rate) is a rate that reflects what banks need to pay other banks when they borrow money for a period of one year any where in the world.

The margin is a constant that when added to the index rate yields the new interest rate on your mortgage. What that calculates to needs to be considered before rushing into a refinance.

For example, if your mortgage was resetting today to a rate of 1-year LIBOR plus 2.25% you rate for the upcoming year will be 5.50% (3.231% plus 2.25% equals 5.481% which is rounded up to the nearest 0.125% making the rate 5.50%). This is assuming that the rate cap specified in the “Note” isn’t crossed. If the rate cap yields a rate lower than 5.50%, then that is the rate you will be adjusting to.

With fixed rate mortgages today costing 6.50% should you be rushing to refinance into a fixed rate? You still may elect to refinance for other reasons but you certainly shouldn’t be doing it because of the new rate.

When you originally closed on this mortgage you had made the decision that it was the best product for your situation. Don’t let the news media lead you into a refinance when in fact this still may be the cheapest financing available. Make your decision based on the specifics of your mortgage and how it fits into your current financial situation. Don’t feel forced to refinance because it appears to “be the thing to do”.