As mortgage rates trend higher, many would-be home buyers are having to reconsider their financing options. Of course, higher interest rates mean higher monthly payments and higher qualifying ratios. With this double-whammy, potential buyers may not be able to afford or qualify for the standard fixed-rate mortgage.

Rather than waiting for a higher income or lower rates to come along, borrowers can consider an alternative in the form of the adjustable rate mortgage (ARM). In this type of mortgage the initial interest rate is usually lower than the going fixed-rate mortgage. The catch is that the rate periodically changes in accordance with some measure or index of how interest rates are changing over time.

The benefits are that the buyer may qualify for the ARM, whereas they may not qualify for a fixed-rate loan. Furthermore, with such safeguards as adjustment caps and life-of-loan caps (limits on how much a rate can change) borrowers can be protected from unexpectedly large increases to their monthly mortgage payments.

But ARMs come in many varieties, and the complexities can cause understandable reluctance on the part of borrowers to embark on an uncertain journey. The standard tools used to give a picture of what may be expected are: 1.) a list of values showing where the relevant index stood at the end of each year in a ten-year period, 2.) a graph of the index over a period of time, and 3.) an annual percentage rate calculation. Let's look at the shortcomings of each of these tools.

A list of index values will not show how the value translated into a new mortgage rate and how the new mortgage rate may have affected a new monthly payment amount. A second problem is that if the values went primarily in one direction, then the list would be misleading because interest rates do not always trend in one direction.

A graph showing how the index has moved over time may be misleading depending upon the time interval between the index values that are used to make the rate adjustments. In addition to this, the graph does not show how actual adjustments compared to the plot of the index values.

And a shortcoming of the annual percentage rate (APR) is that in order to know the costs per year of the financing, one needs to know the interest rate for each year. One might calculate the worst case scenario to the limit of the life cap, but this would paint an unfairly bleak picture of what the costs were. The official method is to calculate the progress of the loan on a worst case scenario basis but only until the fully-indexed rate is reached; that is, up to the rate that equals the initial index value plus the margin that is used in the adjustment calculations. Is this a valid barometer? Does it enlighten and inspire confidence in the borrower?

The purpose of this essay is to lay out the basics of the adjustable rate loan and look at how loans in the past may have progressed over time. The essay will employ the standard 1-year, conventional, conforming, 30-year ARM since it is the most prevelant and the easiest to find historical information on. For ease of illustration, certain assumptions have been made regarding the rate changes that might not correspond to actual events. Examples should not be construed as reflecting real case studies, but they should provide a generally accurate picture of how the rates of an ARM have changed over time and the effect of the changes on monthly payment amounts.

To understand adjustable rate mortgages, one needs to look at both sides of the transaction. ARMs began in the 1980's as a means of making mortgage financing possible in a high interest rate environment. If lenders (and by extension, investors in mortgage backed securities) cannot lend their product (money), they cannot profit from it. Without being able to take advantage of the high rates, a compromise was made. Rather than making the investment based on long term interest rates, the lender/investor made the investment on the basis of short term rates. With short term investments, the investor keeps up with the going rate because the money comes back to be reinvested. But since the mortgage lender has a longer termed investment in which only some of the money is returned in the shorter time interval, the risk of losing an increase in yield somewhere down the line was partly transferred to the borrower.

The matter of pricing the mortgage is determined by what the lender could get for a more risk-free investment and then adding an amount to the yield to cover the risks involved in mortgages. Since mortgage lenders face the risk of losing their expected yield due to prepayments and defaults, they demand a higher return for their money. This is why an adjustable loan has a margin, an amount that is added to the index value when the rate adjustments are calculated. The higher the margin, the greater the chance that the adjusted rate will be higher. Lower margins, therefore, are more desirable from the borrower's perspective but they require an additional fee to obtain.

As mentioned above, the borrower is protected to some extent by limits to how much the interest rate can change.

The basic outline of how a standard 1-year ARM works is this. Based upon the initial interest rate, a monthly payment amount is calculated that would cover both principal and interest if the rate were fixed over a thirty year period. Twelve payments at this amount are made before that amount could change. But before the thirteenth payment is due, a new interest rate is calculated. This is done by taking the index value, adding the margin percentage and observing the restrictions of the rate cap. The result is rounded to the nearest eighth and the new rate is then used to calculate the monthly principal and interest amount that would be necessary to pay off the loan in twenty-nine years. This procedure is repeated each year.

The index in this case is called the 1-year constant maturity. It is sometimes called the T-Bill, though this is not accurate. Each week, the Federal Reserve puts out a compilation of statistical information called publication H.15, Selected Interest Rates. This includes the daily data on what Treasury securities were yielding. The one year constant maturity is the average of all of the yields on bills that mature in a year or less. The securities that have less than one year maturities are annualized; that is, the yield is calculated as if the funds from the retired bills were rolled into securities with the same pricing determinants until a year had transpired. Each of the daily 1-year constant maturity figures are then averaged for a weekly total. This is the index number that is used for the standard 1-year ARM loan adjustments.

The weekly index value that is used depends on the date of the mortgage note. Closings take place prior to the date of the mortgage. At closing the money changes hands and the interest clock starts ticking. Interim interest is paid at that time to cover the period up until the date of the mortgage note, which is normally the first day of the following month. After this interest payment, all interest is paid in arrears, meaning that it is paid on time already past, so the first payment will not be the date of the mortgage note but the first day of the following month. The first interest rate change date is the anniversary date of the mortgage note, not the first payment date. Loan servicers look at the index value that was available 45 days prior to the change date in making the adjustment calculations.

The newly calculated interest rate then takes effect on the same date as on the mortgage note, but the first new payment amount takes effect on the anniversary date of the first payment.

Let's look at an example:

We will assume that back in 1984, when 30-year fixed mortgages were in the 13.25% range, a borrower gets a $100,000 adjustable rate mortgage with an interest rate of 11% and margin of 2.75%. Yearly adjustments cannot exceed 2% and during the life of the loan the rate cannot change by more than 6%.

The initial monthly payment works out to be $952.32 and the first payment date is May 1st. Remember, the interest is for April, so the loan probably closed in March. An adjusted interest rate would take effect on April 1st of 1985 and the first new payment would be due on May 1st of that year.

Forty-five days prior to April 1, 1985 was January 15th. This was a Tuesday and the constant maturity index available at that time was for the week ending January 11th. The index was 9.04%. Adding 9.04% and the margin, 2.75%, equals 11.79%. Rounded to the nearest eighth gives 11.75%. Since this rate does not violate the periodic rate cap, it is the new interest rate.

The new payment amount is then calculated by using the new interest rate, 348 monthly payments (12 out of the total 360 will already have been made), and a principal balance amount of 99,549.87 (some of the original loan amount is paid off in the first 12 payments). The new monthly principal and interest amount is $1,008.73, an increase of $56.41 from the initial payment amount.

It should be pointed out that in this particular case the going fixed rate at the time of the first adjustment was still around 13% and a monthly payment on a new 30-year loan of $99,600 would have been $1,124.64.

Each year the process is repeated.

Click here to view the example in an amortization table and graphs.