Adjustable Rate Mortgages or ARMs

Many different kinds of Adjustable Rate Mortgages have originated with their own features with the result that not all Adjustable Rate Mortgages are even referred to as ARMs. Terms such as VRM (Variable Rate Mortgage) ROM(Roll-Over Mortgage),RRM(Renegotiated-Rate Mortgage) and the like are used to refer to ARMs.

To understand the complex features of an adjustable rate mortgage, the structure of a California VRM used by a savings and loan association is given below:

The mortgage interest is based on the weighted average cost of savings index published by the Federal Home Loan Bank of San Francisco. In general, the spread between the mortgage rate and the index rate is held constant: that is, when the index changes, there is an equal change in the VRM interest rates. However, there is other provisions which may prevent such equal changes taking place all the time.

The mortgage interest may change (up or down) only once in any six - month period and may not change at all during the first six months.

The mortgage interest may not change (up or down) more than 0.25 %( 25 basis points) at a time, no matter how much the index changes. Combined with provision (ii) above, this means that the mortgage interest may not change more than 0.5% per year.

The mortgage interest rate must change at least 0.1 %( 10 basis points) at a time, except to bring the rate to a level previously impossible because of the 25-basis- points limitation. For instance, if the index rises 5 basis points from the original level, the VRM rate would not rise. However, if the index rises 30 basis points from the original level, the VRM rate will rise by 25 basis points(the agreed upon maximum) after six months, and by the other 5 basis points in other six months.

The mortgage interest rate may not rise more than 2.5 percent (250 basis points) higher than its initial level, no matter how much the index rises.

Increases in the mortgage rate are optional on the part of the lender, but decreases or mandatory.

Within 90 days of anytime the mortgage rate is increased, or at any time the mortgage rate exceeds its initial level, the browser may prepay the loan in whole or in part without prepayment penalty.

Whenever the mortgage rate is increased to a rate higher than its initial level, the borrower may opt to keep his monthly payment constant by extending the maturity of the mortgage. However; there is usually a limit up to which the extension of the maturity period will be allowed. For example, a 30-year mortgage may give the option to the borrower to extend the term by 10 years, which means that the total term to maturity of the mortgage can not exceed 40 years.

Thus, ARMs have a number of complex features:

ARMs can have maturities that vary as well as interest rates. It is impossible to calculate in advance the exact amortization schedule for an ARM.

Provisions (iii) and (v) listed as features of California ARMs are common features of almost all Adjustable Rate Mortgages. The provision that in any period, the interest can not change beyond a specify basis points is referred to as a “periodic cap’.The provision that the mortgage interest rate may not rise above 2.5%(250 basis points) during the term of the maturity is referred as life time cap.

Another provision found on many adjustable rate mortgages are negative amortization. The borrower may be allowed to maintain a constant monthly payment after an interest rate increase by opting to add any interest short fall to the outstanding mortgage balance. This process is allowed to continue until the mortgage balance reaches a maximum amount at which time payments must rise.

In spite of all the complexities, the ARMs became popular due to the following reasons:

1. Adjustable Rate Mortgages reduces interest rate risk for the lender.Hence,thrift institutions such as the Ls,ARMs, offer obvious advantages in spite of the life time caps.

2. Borrower accept ARMs because the lenders by offering lower initial rates express their preference for ARMs. Depending on the competitions and aggressiveness of the lender, the initial interest rate on ARM could be half percent to two percentage points or more below the rates being quoted for fixed –rate mortgages. Arms tend to be most popular when interest rates are highest and buyer’s are hunting for arrangements that could lower initial outflows.

The disadvantage of Adjustable Rate Mortgages is that they are difficult to be sold in pooled or security form as there are no standard clauses. It is difficult to find large quantities of anyone kind of ARM, as there are diversity in initial interest rates, index,interest rate reset frequency, periodic or lifetime caps and so on.