Do you have a broken ARM? (Adjustable Rate Mortgage)
Next year, over a Trillion dollars of Intermediate-term adjustable rate mortgage will have their initial interest rates adjust! Is now the time to cut off your arm? Maybe, but maybe not.
The key to this question is finding out exactly what your arm will do when it adjusts.
To help determine this, a few definitions are in order:
* Index: This is the basis for determining the interest rate. The most common indices are the 1-year Treasury Index, Libor Index, Cost of Funds Index and MTA (monthly treasury index).
* Margin: The margin is a percentage added to the Index to determine your interest rate. Index + Margin = Interest Rate.
* First Adjustment Cap: This cap limits the amount the interest rate can change at it’s very first adjustment.
* Annual Rate Cap: This limits how much the rate change year over year, after the first adjustment.
* Lifetime Rate Cap: This limits how much the rate can change over the life of the loan.
When your arm rate adjusts, it will be based on the index + margin, subject to the caps. For example, say you have a 5/1 arm adjusting next year. You have been locked-in at a phenomenal 4% rate over the past five years. Your loan has a Libor Index with a 2.25% margin, a 2% first-adjustment cap and a 2% annual cap. If the Libor index were around 5% at the time of adjustment, your new rate after adjustment would only be 6%! That’s lower than today’s prevailing 30 year fixed rates.
Huh? Let me explain:
Your rate is the sum of the Index + Margin, subject to caps. So a Libor index of 5% plus 2.25% = 7.25%. But in this example, your loan has a 2% first adjustment cap. So if the initial rate were 4%, the highest the rate could go at the first adjustment is 6% because it is limited by the 2% cap.
But what if your loan had a first-adjustment cap of 5% (as many do)? Then your rate would adjust to 7.25% (Index of 5% + 2.25% margin).
Should I refinance now? I would say that depends on how much your first-adjustment cap is. If you have a 2% cap, you’re probably not in any immediate danger of a whopping jump. But if your first-adjustment cap is higher, you may want to step up the process.
If I let my rate adjust, how is my payment calculated? When your rate adjusts, your new monthly payment will be calculated on the new rate, the remaining term of the loan, and the remaining balance of your loan. If you have paid down the principal balance on your loan, your payment may not jump as much as you think!
Eric’s Rate Forecast: All of the turbulence in the financial markets may have a silver lining. The slowdown in the national real estate market combined with market instability has increased the possibility of an economic slowdown or even a recession next year. Interest rate follow the economy, so there is a growing probability that we will see interest rates decrease over the next year.
If we’re lucky, rates will look very favorable at just about the time you need to decide whether to refinance or to hang on to your arm.
So take a closer look at your arm. It may not be broken after all!
