An ARM is a loan which allows for the adjustment of its interest rate according to the terms of the note and as market interest rates change. The ARM interest rate is based upon one of many indices which reflect market interest rates. The borrower assumes the risk that interest rates (and their monthly payment) will rise. By assuming this risk, lenders may charge a lower initial interest rate compared to fixed rate loans. The lower initial rate is the main reason borrowers choose ARM loans–it allows them to qualify for a larger loan and obtain a higher-priced home.

Borrowers considering an ARM should familiarize themselves with standard ARM features. These features include:

• Start rate (Teaser rate): This temporary rate is the starting interest rate. It is often referred to as the teaser rate. The start rate is lower than the fully-indexed rate (sum of the index plus the margin), and lower than the market rate on fixed loans.
• Initial Adjustment Period: The length of time the interest rate is fixed initially. For example, if the initial adjustment period were six months, the interest rate would remain fixed for the first six months. Beginning in month seven, the loan would adjust at regular intervals.
• Regular Adjustment Period: The frequency at which the interest rate adjusts. If the regular adjustment period were six months, the interest rate would adjust every six months.
• First Adjustment Cap: The maximum amount the interest rate can increase when it adjusts for the first time. For example, if your teaser rate and first adjustment cap were 5 percent and 3 percent respectively, the maximum your rate could increase after the initial adjustment period would be 8 percent.
• Regular Adjustment Cap: The maximum the interest rate can adjust up or down each adjustment period.
• Lifetime Cap: The maximum interest rate allowed over the life of the loan.
• Index: The variable index referenced in your note. The margin is added to the index to set the ARM interest rate. The index can usually be found in business newspapers. More information about various indices is available below.
• Margin: A fixed number which is added to the index to arrive at the ARM rate.
• Fully-indexed rate: The fully-indexed rate is equal to the index plus the margin. Your loan always adjusts toward this rate.
• Conversion Options: Some ARMs have an option which allows the borrower to convert the ARM to a fixed-rate loan. Exercising the option usually must ocurr within a predetermined time frame; the fixed rate is determined by a formula. For example, a one-year T-bill ARM may be converted to a fixed-rate loan during the first five years on the adjustment date. I.e., you could convert during the thirteenth, twenty-fifth, thirty-seventh, forty-ninth or sixty-first month.

Computing the fully-indexed mortgage rate:

The formula to calculate the fully-indexed interest rate is: fully-indexed rate = value of index + margin

Note: The rate you pay after one or more adjustments may not be the fully-indexed rate. This can occur when the interest rate adjustments are limited by a cap.

Examples:

1. Not reaching the fully-indexed rate: Say your previous rate was 7 percent, your loan has a 1 percent adjustment cap, the index is 7 percent, and your margin is 3 percent. The fully-indexed rate is 10 percent. Because of the limiting payment cap, your new interest rate is 8 percent.
2. Reaching the fully-indexed rate: Now say your previous rate was 7 percent, your loan has a 3 percent adjustment cap, the index is 7 percent, and your margin is 3 percent. After the adjustment, your interest rate reaches the fully-indexed rate of 10 percent.

Details about the various indices:

1. Prime rate: The interest rate banks charge their best (prime) customers.
2. Treasury bill rate: Treasury bills are short-term debt instruments used by the U.S. Government to finance their debt. Commonly called T-bills, they mature in less than one year.
3. Libor: London Interbank Offered Rate. The interest rate international banks in London charge when lending to each other. Indices are quoted for maturities of one, three, six and twelve months. The most common Libor rate referred to in ARMs is the six-month Libor rate.
4. 6 month CD rate: The average rate that banks pay on a six-month Certificate of Deposit.
5. 11th District Cost of Funds Index (COFI): The index is the average monthly cost of the interest expenses incurred by members of the 11th District of the Federal Home Loan Bank System. Deposits in checking and savings accounts, certificates of deposit, transactions accounts, and passbook accounts are the primary source of funds for these savings institutions. The COFI moves slowly and lags behind the market. For COFI ARM borrowers, this is an advantage when interest rates are rising, but a disadvantage when rates are falling. When rates are rising, the COFI rate, and consequently the ARM rate, will rise slowly. Conversely, when rates are falling, the COFI rate and ARM rate will decrease slowly.

Popular ARM programs. Some of the more popular ARM programs include:

• One-Year Treasury Bill ARM - Adjusts annually with a two percent annual cap.
• Six-Month Certificate of Deposit (CD) ARM - Adjusts every six months with with an adjustment cap of 1 percent. The CD rate is very volatile and changes quickly with the market.
• Six-Month Treasury Average ARM - This index is relatively stable because it averages the treasury rate over the previous six months. This loan has a maximum interest rate adjustment of 1 percent every six months.
• Twelve-Month Treasury Average ARM - This index is relatively stable because it averages the treasury rate over the previous twelve months. This loan has a maximum interest rate adjustment of 2 percent every twelve months.
• Three-month COFI ARM - The COFI is one of the most stable indices and adjusts very slowly. The three-month COFI ARM typically has a very low start-rate for the first three months, after which time the interest is fully indexed and adjusts monthly.

Intermediate ARMS

Lenders also offer ARMs which feature an initial adjustment period with an intermediate time frame. The most popular intermediate ARM loans are the 3/1, 5/1, 7/1 and 10/1. These loans are normally amortized over thirty years with the interest rate initially fixed for three, five, seven and ten years respectively. After the initial fixed period, these loans typically adjust annually.

Intermediate ARMs are very popular with borrowers who want the stability of a fixed rate and the benefit of a lower introductory rate. If you plan to sell or refinance your home in three to ten years, you may want to consider an intermediate ARM loan rather than a fixed-rate mortgage. You can save money with the lower introductory rate, but you risk having a higher rate if you are still in your home when the introductory rate period expires and the rate starts adjusting toward market levels.

An Energy Efficient Mortgage, or EEM, may provide home buyers with the ability to qualify for a larger loan than a traditional mortgage loan. Whether the purchase is a new or existing home, one that is already energy efficient or one that the buyer will make energy efficient following the purchase, the idea behind the EEM is simple.

A more energy efficient and therefore more affordable home enables you, the home buyer, to qualify for a larger loan. The EEM accounts for the home owner spending less money on energy consumption and applies that savings as income in underwriting the loan. Case in point: A mortgage customer with a gross income of $50,000 might qualify for a $187,000 home with a traditional mortgage loan, but with an EEM loan that figure could increase to a borrowing capacity of $202,000!

Qualifying for an Energy Efficient Mortgage is similar to qualifying for a traditional conforming mortgage. The underwriter considers the mortgage applicant’s credit score, debt to income ratio, ability to repay the loan, etc. – just like a traditional loan. The application process differs in that it begins with a HERS (Home Energy Rating System) report on the existing home or the plans of the new home being built. With new homes, the report identifies how energy efficient the home is, while with existing homes, the report identifies how the home’s energy efficiency can be improved through the installation of energy saving features.

For existing homes, the cost of the proposed efficiency updates can actually be financed through your EEM loan. When the HERS report is presented, it details the current energy efficiency of the home and provides a checklist of improvements that can be made to improve the home’s energy efficiency. Consumers can then borrow up to 15% of the home’s appraised value in order to make the energy efficient improvements. For a home that appraises at $200,000, you could finance up to $30,000 for energy efficient upgrades!

The important thing to understand about Energy Efficient Mortgages is that can potentially help borrowers leverage a slightly larger loan amount than they might otherwise qualify for. EEMs don’t necessarily impact the interest rate on the loan: As with any mortgage, the interest rate is tied to a buyer’s credit score. That said, there is a effort undertaken by the Energy Programs Consortium to enhance EEM products by offering reduced rates, but as of this writing that has not yet materialized.

Thus, the benefit of the current structure of Energy Efficient Mortgages EEM lies in the debt to income ratio adjustments that result from the underwriting process in an Energy Efficient Mortgage. The incentive for homebuyers to utilize EEM’s comes from realizing the benefit of lower utility bills, being able to qualify for a more expensive home and knowing that their home’s carbon footprint is as small as it can be.

Libor ARMs are only a good deal if the savings on the front end outweighs the risks of increased rates and payments later on.

Libor stands for “London InterBank Offer Rate”, and is the interest rate offered on banks in London which have large deposits of US money. The rates are fixed for a set time-period; typically 1 month, 3 months, 6 months, and 12 months. After that, rates are adjusted based on the current value of the Libor, plus a pre-determined margin.

For example, suppose you have a 3-month Libor ARM with an introductory rate of 3.15%, and a margin of 1.5%. At the end of the first three months, your new rate will be 1.5% plus the current rate of the 3-month Libor. So if the current rate is 3%, then your new rate is 4.5%.

If you’re considering a Libor ARM, find one that has an adjustment cap. Using the above example, if you have a rate cap of 1%, then your new rate is only 4.15%.

We recommend that you compare the features of a Libor to other ARMs before making a final decision. You need to do a careful comparison of rates, margins, and adjustment caps, in addition to other features. And, as always, we recommend that you talk with a reputable mortgage broker.

The most likely — and most frustrating — reason could be because of the lender. Many people, when they decide to refinance, go to the lender that’s servicing their existing mortgage. It may be the easiest refinancing option, but it can also take longer than refinancing with another lender. Because the lender already has your business, you’re not a high priority. That will be especially true if you’re refinancing to get a lower interest rate, which means the lender will lose money.

There are other possible reasons, though, that have nothing to do with which lender you choose:

Loan to value ratio is too high: If your property appraises significantly below the amount of the loan you’re seeking, you may not be approved for a re-finance. This can happen if property values decrease in your area, or if your initial loan negatively amortizes.

Poor Payment History: If you’ve made late mortgage payments, some lenders won’t re-finance your loan.

Change in Your Financial Situation: If your income has decreased, or if you’ve taken on additional credit card debt or some other kind of debt, it can affect your ability to re-finance. The change in your financial situation may cause lenders to view you as more of a risk than previously.

If you’re considering re-financing, we recommend that you first get an accurate picture of your current finances and the status of your current mortgage. We also recommend that you don’t automatically default to your current lender. Remember to shop around. You may find better rates or closing costs elsewhere.

Most people refinance to get a lower interest rate. They figure that a lower interest rate will automatically translate into saving money, but this may not be completely true. You also have to consider the term for the new loan. If you lower your interest rate by 2% but the life of your loan increases from 15 to 30 years, you’re not actually saving any money because you’re paying more in long-term interest. Refinancing can definitely lead to significant savings, but it’s most likely if you’re able to reduce the interest rate and the loan’s term is the same or shorter.

Closing costs are another expense you need to consider. In order to determine your “break even” point on a refinance, you should divide the closing costs by the reduction in your monthly payment. In other words, if it costs you $2000 to refinance, and your mortgage payment is $100 less, you divide 2000 by 100 and that’s how many months it will take you to recover your costs.

Here are some good reasons to refinance:

• you’re saving interest long-term
• you’re using the money you’ll get back to pay off high-interest credit cards or other debt
• you’ll be in the house long enough to recover your closing costs
• you have an ARM that you’re converting to a fixed-rate mortgage

There may be other situations in which refinancing is a good option, depending on your particular situation. Consult with a mortgage broker or financial advisor before making a final decision.