If you pay attention to the overall mortgage lending landscape, you’ve likely noticed an uptick in ARM lending. Perhaps you’ve even noticed it in your own lending shop.
Thanks to rising interest rates, ARM loans are starting to look a bit more favorable to some lenders and savvy borrowers. The rest of the population, however, may need a little encouragement in understanding how ARM loans can be an attractive alternative to fixed-rate loans.
As a lending professional, being able to present ARM loans as a credible product option while dispelling some of the common misconceptions demonstrates your interest in presenting the most suitable options available to your borrowers.
ARM loans do elicit numerous questions from lenders and borrowers alike. To help you bridge the knowledge gap, we’ve outlined how to talk to your borrowers about ARM lending and how it can be a good option for them.
Benefits of ARM Loans
Let’s talk about the benefits of ARM loans first:
Lower Interest Rates
ARM loans provide borrowers rates below fixed-rate products as the initial interest rate is only “fixed” for a set-period of time, versus the full term of the loan. Ranging typically from 1 to 10-year periods, the shorter the duration of the ARM period, the greater the rate benefit compared to a long-term fixed product.
In today’s market, the 5-year ARM is most prevalent and offers an approximate half point (.50%) advantage to the 30-year Fixed product. At the time of this writing, market 5-year ARM rates are at 3.875% while the 30-year Fixed is at 4.375%.
Lower Payments, Less Interest & More Home Equity
Lower rates mean lower payments. Using the example below on a $200,000 loan, the rate difference provides a $59 monthly payment savings. After 5-years that is $3,540. Lower payments afford lower interest expense and increased principal benefit. After 5-years of minimum required payments, the remaining principal balance on the ARM loan would be $1,441 lower than its Fixed-rate peer plus the interest paid would be $4,981 less. (Rates and calculations from Bankrate.com, pulled 01/17/19)
|Loan Product and Rate $200,000||5 Years of Monthly Payments||Interest Expense after 5-years||Unpaid Principal after 5-years||Home Equity|
|5/1 ARM @ 3.875||$56,400||$36,927||$180,527||$19,473|
|30-yr Fixed @ 4.375||$59,940||$41,908||$181,968||$18,032|
|5-yr ARM benefit||$3,540 savings||$4,981||$1,441 Additional Equity|
More money in your borrower’s pocket and more equity achieved in their home = Win-Win!
During the application process, the rate used to qualify the borrower may vary based on the duration of the initial ARM adjustment period.
|Amortization Type||Qualifying Interest Rate|
|6-Month to 5-Year ARMs||Greater of the fully indexed rate or the note rate + 2.0%|
|7- to 10-Year ARMs||Greater of the fully indexed rate or the note rate|
It should be noted that at each adjustment period, there is the chance that the interest rate could go down in the right rate environment.
ARM Terms to Be Familiar With
It’s important for ARM loan borrowers to be familiar with some unique terms related to ARM loans. Knowledge of these terms will help a borrower prepare for scheduled changes throughout the life cycle of their ARM loan. Here are some of the key terms to understand:
|Term||Why It Is Important|
|Index/Index Rate||The published benchmark that will determine the loan’s interest rate. Ex. Treasury Bills, COFI, Prime Rate|
|Margin||The amount added to the Index Rate to determine the loan interest rate|
|Adjustment Period||Period of time between scheduled rate adjustments. Examples:
3/1 ARM – First adjustment after 3 years, every year thereafter
3/3 ARM – First adjustment after 3 years, every 3 years thereafter
5/5 ARM – First adjustment after 5 years, every 5 years thereafter
|Cap: Initial, Periodic, Lifetime||1. “Initial” Adjustment: maximum rate adjustment at the first rate change
2. “Periodic” Adjustment: maximum rate adjustment at each subsequent adjustment
3. “Lifetime”: maximum amount a loan interest rate may adjust over the lifetime of the loan
|Floor and Ceiling||Floor is lowest interest rate an adjustment rate can go. Ceiling is the highest an ARM loan can adjust over the life of the loan.|
|Fully Indexed Accrual Rate (FIAR)||The index plus margin. Used to calculate the initial and all subsequent rate adjustments|
|Initial Rate/ Start Rate/Teaser Rate||Some ARM loans are offered with a “teaser rate” for the initial loan rate. These rates are offered at a discount to the FIAR and remain in place until the first adjustment period.|
|Conversion Option||Some ARM loans provide a conversion to fixed rate option. This allows a borrower to convert the loan from an ARM to a fixed product for the remaining term of the loan. Terms of the conversion are clearly stated in the loan documentation.|
Who’s a Good ARM Loan Candidate?
ARM loans aren’t for everyone. However, there are a few segments among your borrower population that might be more open to learning more about them.
Recent graduates and young professionals have the greatest potential for income increases as they establish themselves in their careers. That means they could reasonably afford potential rate increases at each adjustment period. They’re also a likelier population to move around more, meaning they could move out of their home before the first adjustment period.
“Roving” professionals are another segment to target. They know that they will move around more for work. They could benefit from the low initial ARM rate and move before the first adjustment period.
As interest rates continue to rise, we’ll certainly notice an uptick in ARM loans. We encourage you to familiarize yourself with ARM loan products so you can fully inform your borrowers of all of the products available to them in today’s market. Our training course on ARM loans is a great place to start.
Check back next week when we bust ARM loan myths and go into more detail on the benefits borrowers receive from ARM loans.