"I have been told that I need an ARM to qualify for the loan I want, and that terrifies me because I don't understand how ARMs work. Can you explain it in simple terms?" 

I'll try, beginning with a definition.

Adjustable Rate Mortgages Defined

An ARM, short for "adjustable rate mortgage", is a mortgage on which the interest rate is not fixed for the entire life of the loan. The rate is fixed for a period at the beginning, called the "initial rate period", but after that it may change based on movements in an interest rate index. ARMs are contrasted with fixed-rate mortgages (FRMs) on which the quoted rate holds for the entire life of the mortgage. See Fixed-Rate Mortgages.

ARM Rates and Rate Relationships

The ARM rate quoted by a lender or broker is the initial rate. It holds until the end of the fixed-rate period, which can last from a month to 10 years. This rate is critically important if the initial rate period lasts for 10 years, but it is very unimportant if the period is only one month.

The ARM rate tends to rise with the initial rate period. It is the lowest on ARMs with initial rate periods of a year or less, and highest on the 10-year version, which comes closest to an FRM. Typically, the rate on a 10-year ARM is only .125% or .25% below that of a comparable FRM.

The rate spreads between ARMs with different initial rate periods vary over time with changes in the market yield curve. The yield curve is a graph that shows, at any given time, how the yield varies with the period for which the rate holds. When the yield curve is upward sloping, as it was in 2003, rate differences between ARMs and FRMs, and between ARMs with different initial rate periods, are large. When the yield curve is flat, as it was in 2006, these rate differences are small. This has clear implications for borrower selection decisions.

The "Get-Out-Before-the-Rate-Adjusts" Strategy

Many borrowers adopt the strategy of selecting an ARM with an initial rate period longer than the period they expect to be in their house. If they confidently expect to be out within 5 years, for example, they can select a 5-year ARM and enjoy the rate saving relative to longer ARMs and to FRMs.

However, if there is some uncertainty about how long they will be in their house, which is usually the case, their selection decision will be affected by how large the ARM savings are. Consider a borrower who expects to be out of the house in 5 years but is far from certain that he won't be there longer. If the rate difference between the 5-year ARM and the comparable 30-year FRM is 1% or more, as was the case in 2003, the savings over 5 years might justify the risk. If the rate difference is only .25%, as was the case in November 2006 when this article was revised, the borrower might well decide to take the FRM and be safe.  

Considering the ARM Rate Adjustment

Only borrowers who are certain they will be out of the house before the first rate adjustment can afford to ignore what might happen to their rate and payment at that point. This question can be addressed in two stages.

In stage one, you make the assumption that market interest rates don't change from the time you take out the loan. This provides an excellent baseline for comparing ARMs. In stage two you assume that interest rates explode. This provides a measure of the riskiness of the ARM. Call these "no change" and "worst case" scenarios.

Information Required

To perform the analysis, you need to get 5 pieces of information about the ARM from the loan provider:

1. The most recent value of the interest rate index to which the rate on your ARM is tied.

2. The margin that is added to the index value to determine the rate.

3. The rate adjustment period, which is the frequency with which rates are changed after the initial fixed-rate period is over.

4.  The rate adjustment cap limiting the size of any rate change, if any.  NOTE: ARMS THAT HAVE INITIAL RATE PERIODS OF 5 YEARS OR MORE AND RATE ADJUSTMENTS ANNUALLY THEREAFTER ARE LIKELY TO HAVE HIGHER RATE CAPS ON THE FIRST THAN ON SUBSEQUENT RATE ADJUSTMENTS.

5. The maximum rate over the life of the loan.

No-Change Scenario

On a no-change scenario the rate on the ARM will adjust to equal the sum of the index value plus the margin, sometimes called the "fully indexed rate" (FIR). It will adjust in one or more steps, depending on whether there are rate adjustment caps.

I use as my example a 5/1 ARM on which the initial rate holds for 5 years, after which it adjusts every year. The initial rate is 5%, the index value is 5.5%, the margin is 2.5%, and the maximum rate is 12%. If there is no rate adjustment cap, the rate in month 61 would jump from 5% to the FIR of 8% and remain there. If there is a 2% rate adjustment cap, the rate will go to 7% in month 61, and to 8% in month 73.

Worst-Case Scenario

On a worst-case scenario, the ARM rate will move toward the maximum rate allowed by the loan contract. Assuming the same mortgage and no rate adjustment cap, the rate in month 61 would jump from 5% to the maximum rate of 12%, and remain there. If there was a 2% rate adjustment cap, the rate will go to 7% in month 61, 9% in month 73, 11% in month 85, and 12% in month 97.

In short, when comparing ARMs you will want to consider more than just the initial rate and how long it lasts, which is as far as many ARM borrowers go. Unless you are sure you will be out of the house before the fixed-rated period ends, you also want to consider what will happen to the rate, and when it will happen, on no-change and worst-case scenarios.

A word of warning. The loan officer will give you all the information you need for this analysis with the possible exception of the index value, on which he may profess ignorance. That's OK. It is probably safer to find this number on your own but you must get a description of the index that is complete enough for you to identify it.  Don't let him tell you it is the "Treasury bill" series because there are a number of Treasury bill series. 

You can find the most commonly used indexes, and web-based sources of information about them, at Adjustable Rate Mortgage Indexes. 

Copyright Jack Guttentag 2006