Is a 3.95% Adjustable Rate Mortgage a Good Deal?
February 21, 2000

"Despite rising interest rates in recent months, I continue to see advertisements for adjustable rate mortgages (ARMs) with a 3.95% rate. Why hasn’t the rate on this ARM risen with other rates? Is this a bait and switch, or what?"

It is not a bait and switch, 3.95% ARMs do exist. They fill an important market need. They also carry special risks that borrowers should understand.

The interest rate quoted on an ARM is only the start rate, which can hold for periods ranging from one month to 10 years. On a 3.95% ARM, the start rate holds only for a month. In month two, the rate jumps from 3.95% to a current market rate, and it adjusts every month thereafter.

While the rate on the 3.95% ARM adjusts each month, your payment adjusts once a year. The initial payment, calculated at 3.95%, holds for the first year. Furthermore, subject to an exception I’ll note below, the payment cannot rise by more than 7.5% per year.

The 3.95% ARM is a rising payment mortgage. If market interest rates don’t change after the loan is closed, the payment will rise for a number of years before it levels off. In the early years of the loan, the monthly payment doesn’ments on other types of mortgages. In addition, if interest rates don't increase over the life of the loan, the borrower will probably pay lower interest costs on the 3.95% ARM than on a 30-year fixed-rate mortgage (FRM).

I recently examined a typical 3.95% 30-year ARM. The index it uses was 4.968% in January and it had a margin of 2.15%. The loan rate in each month after the first month is the sum of the index plus the margin. This loan also had a maximum rate of 11.60%.

First, I examined a "no-change" interest rate scenario. In month 2, the rate jumps to 7.118% (2.15 + 4.968) and remains there. (This was well below the 30-year FRM rate at that time). Assuming a loan of $100,000, the monthly payment for the first year, calculated at 3.95%, is $475.

In months 13, 25, 37, 49, 61, 73 and 85, the payment increases by 7.5%, reaching $742 in month 85. There it remains until the end of the term. The $742 payment is "fully amortizing", meaning that it will pay off the loan over the remaining term at the interest rate prevailing in month 85.

In this scenario, the loan balance increases to a peak of $103,299 in month 48 before it begins to decline. It isn’t until month 89, however, that it returns to $100,000.

Rising payments with negative amortization is the price you pay for affordable payments in the loan's early years. If interest rates decline, the payment will not increase for as many years, and negative amortization will be smaller. If interest rates increase, however, the period of payment increases will be longer and negative amortization will be larger.

Rising interest rates pose a special risk because the loan has a negative amortization maximum. In the loan described above, the maximum is 25% of the original loan amount. Once the loan balance hits the maximum, the monthly payment is immediately raised to the "fully amortizing" level, overriding the payment cap. The payment increase in such event can be substantial.

How substantial?

I calculated the payments on the ARM described above in another scenario where the index increases by 1% each year for 5 years beginning in month 13. The ARM rate thus rises to 8.118% in month 13, 9.118% in month 25, 10.118% in month 37, 11.118% in month 49, and 11.60% (the maximum rate) in month 61.

In this scenario, the negative amortization cap is reached in month 82. At that point, the payment jumps from $732 in month 82 to $1298 in month 83, a 77% increase.

This is an unlikely event, but not impossible.

The 3.95% ARM can put homes within reach of some consumers who couldn’t otherwise afford them. In a stable or declining interest rate environment, this can work very well for them, especially if their home is appreciating in value. The risk is that in a rising interest rate environment, they may face a massive payment increase they might not be able to manage.

If you need the 3.95% ARM to buy your dream, and if you understand and accept the consequences and risks, go for it.
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