22 March 2004

"Could you give me the pros and cons of COFI loans?"
"My broker said I need a Libor ARM. What is that?"
"The loan officer said an MTA loan was the best. Is that true?"

These 3 questions illustrate a common but confusing practice in the way adjustable rate mortgages (ARMs) are marketed. Loan officers often identify different types of ARMs by the interest rate index they use. COFI, Libor and MTA are all rate indexes. The sales pitch is based on one feature, often the index itself.

This is misleading because ARMs have multiple features, some more important to the borrower than the one being pitched. Here is the list of major features for ARMs that do not permit negative amortization.

1. Index

2. Initial rate period and subsequent adjustment period. In the trade, these two numbers are usually used to classify ARMs. For example, an ARM on which the initial rate holds for 3 years and is then adjusted every year is a "3/1".

3. Most recent index value and margin. The sum is called the "fully indexed rate", or FIR. For example, if the current value of the index is 2% and the margin is 2.5%, the FIR is 4.5%. If the index does not change over the initial rate period, the new rate will be the FIR, subject to the first adjustment cap.

4. Rate Adjustment Caps: These limit the size of any change in rate. Caps on the first rate adjustment can range from 1%, which would be common on an ARM that adjusts after 6 months, to 5% on an ARM that doesn't adjust for 10 years. Caps on subsequent adjustments are usually 1% or 2%. As an illustration, a 7/1 ARM might have a cap of 5% on the first adjustment and 2% on all subsequent adjustments.

5. Maximum Interest Rate: This is the highest interest rate allowed on the ARM over its life. It is often defined as a spread above the initial rate.

Because these features can vary widely among ARMs that use the same rate index, the notion of "pros and cons" for ARMs that use a particular index doesn’t make any sense. For example, one lender I know offers 9 ARMs that use Libor. Here are two that illustrate my point most dramatically:

6 mos/6 mos: The initial rate of 2.125% holds for 6 months and is adjusted every 6 months thereafter to equal Libor plus a margin of 2.25%. All rate changes are capped at 1.5% with a maximum rate of 15.125%.

10/1: The initial rate of 5.625% holds for 10 years and is adjusted every year thereafter to equal Libor plus a margin of 2.75%. The first rate change is capped at 5%, subsequent changes at 2%, with a maximum rate of 10.625%.

It is easy to understand why loan officers avoid these details if possible. They take time to explain. Getting involved in details violates Salesmanship 101.

Borrowers should demand the information shown above for any ARM being offered them, but they should not depend on loan officers to assess it. They can do that better themselves. Here is how:

The bottom line is how the ARM rate and payment may change in the future, relative to other ARMs or to fixed-rate mortgages (FRMs). You can determine this from calculators available on-line, including my calculator 7a which was designed for just this purpose.

You have to feed the calculator the information it needs to do its job. Part of this is the data on features described above which you get from the loan officer. The second part is your assumptions about how the index will change in the future. You should use multiple assumptions that bracket the relevant possibilities. These are the 5 that I often use:

1. No Change: the index stays where it is now.

2. Small rate increase: after 2 years, the index increases by .5 % /year for 3 years.

3. Moderate rate increase: after 1 year, the rate index increases by .75%/year for 4 years.

4. Larger rate increase: starting immediately, the index increases by 1%/year for 5 years.

5. Worst case: the ARM rate immediately goes to the maximum allowed by the note.

My calculator 7a will allow you to use any or all of these scenarios, or any others including rate declines.

The calculator results won’t tell you which ARM is the best, but it will allow you to make an intelligent selection – and avoid the unpleasant surprises that sometimes await those who passively accept the ARM recommended to them.