That's a challenge because ARMs (short for "adjustable rate mortgages") are complicated, but let me try. First, all ARMs have a fixed-rate period at the beginning, called the "initial rate". That rate is the one quoted by the lender. 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 fixed-rate period lasts for 10 years, but it is very unimportant if the period lasts for only one month.
On the most popular ARM program, the initial rate period is 12 months, and on more than half the period is 36 months or less. While you can always opt for an ARM with a longer initial rate period, the rate goes up as the period lengthens. If you need the rate on a one-year ARM to qualify, you must consider very carefully what happens after the fixed-rate period ends.
You should answer this question 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.
To perform the analysis, you need to get 5 pieces of information about the ARM from the loan officer:
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. WARNING: 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.
On a no-change scenario the rate on the ARM will move toward the sum of the index value plus the margin, sometimes called the "fully indexed rate". On a worst-case scenario, the ARM rate will move toward the maximum rate allowed by the loan contract. If there are no rate adjustment caps, this will happen at the end of the fixed-rate period.
For example, assume the initial rate on a one-year ARM is 5%, the index value is 4.5%, margin is 2.5% and maximum rate is 11%. At the end of the fixed-rate period, the new rate will be 4.5% plus 2.5% or 7% if the index didn't change, and it will be 11% if the index jumped by 4% or more. This is shown below.
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No Rate Adjustment Caps
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Months
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No-Change Scenario
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Worst-Case Scenario
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1-12
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5%
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5%
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13-360
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7
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11
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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 6 Treasury bill series.
