Big Changes for Adjustable Rate Mortgages

Adjustable rate mortgages tend to wax and wane in popularity. ARMs are most popular when there is a large spread between the fixed rate and the adjustable rate. For instance, if the fixed rate is at 5% and a 5/1 ARM is at 3%, more people are likely to choose the ARM. But if the fixed rate is at 5% and the ARM's at 4.75%, few will choose the adjustable rate.

For a refresher course on how ARMs work, click HERE. I'll wait.

I was recently chatting with a friend who is four years into a 5/1 ARM. He's currently enjoying his initial start rate of 2.875%. His first change date is in one year. His index is the one-year LIBOR and his margin is 2.25%.

We know that, in one year, his interest rate will be determined by adding the index (the value of the one-year LIBOR, currently 1.83%) to his margin (2.25%). If his interest rate were to adjust today, his new interest rate would be 1.83 (index) + 2.25 (margin) = 4.08%.

There's just one problem. The LIBOR is going away.

The LIBOR is commonly used as an adjustable rate mortgage index for conforming loans (government ARMs use a different index). LIBOR stands for "London Interbank Offered Rate" and is the rate at which a number of banks borrow money from each other.

LIBOR has been in the news recently due to widespread fraud. Banks were blatantly falsely over- or underestimating their interest rates to profit from trades or to give the impression they were more creditworthy than they actually were. That's not good, since the LIBOR is used as a financial benchmark worldwide. In the US, it's used in determining interest rates on mortgages, student loans, derivatives, and other financial products.

Reports of LIBOR manipulation date back more than a decade(!!) but serious allegations came to light in 2012. As a result, UK regulators now oversee the LIBOR. But they're not going to do it forever. Regulators have set a 2021 deadline for banks and investors to transition away from LIBOR. What does that mean for folks that currently have ARMs connected to LIBOR? The legalese on the paperwork for ARMs states that "if the index is no longer available, the Note Holder will choose a new index that is based upon comparable information."

The New York Federal Reserve convened the Alternative Reference Rates Committee to recommend a new index and ensure a successful transition. Their recommendation: The Secured Overnight Financing Rate (SOFR). The SOFR is a measure of the cost of borrowing cash overnight collateralized by Treasury securities. I'm not exactly sure what that means, but let's run with it.

What's the impact on my friend with the ARM that's adjusting in one year?

The SOFR actually tracks a little lower than the LIBOR. The current value of SOFR is 1.58%, compared to 1.83% for the one-year LIBOR. So if my friend's mortgage was associated with the SOFR instead of LIBOR and if his interest rate were adjusting today instead of one year from now, his new interest rate would be 3.83%. That's better than 4.08%, but still not as good as he could likely get if he refinanced into a fixed rate today.

What else has the AARC recommended?

• Because SOFR tends to be lower than the 1-year LIBOR, the AARC recommends that, in the future, the margin for newly originated SOFR-indexed ARMs be adjusted upward so the borrowers' payments are comparable to existing LIBOR-based ARMs.
   
• In addition, the market standard for ARMs in the US is for interest rates to adjust every year. The recommendation is that new ARMs associated with SOFR have interest rates that adjust every six months.
   
• Lastly, the AARC recommends cutting the periodic adjustment cap to 1%. Currently, most conventional ARMs have adjustment caps so a borrower's interest rate can't increase more than 2% per year. If newly originated ARMs adjust every six months, the recommendation is that the cap change to 1% so a borrower's interest rate couldn't adjust more than 2% per year.

Here's the bottom line for adjustable rate mortgages.

Some people are interested in ARMs because they only plan to keep the mortgage for a short period of time. They plan to pay off the loan or sell the house within the fixed rate period of the ARM. Those folks should continue to operate in the same vein.

But most people get an ARM because it offers a lower payment than a fixed rate mortgage. They still intend to keep the mortgage long-term. I did this when I bought my house. I financed my home on a 5/1 ARM at 2.25% (in 2011). I kept that interest rate for six years. But I could see the writing on the wall. I knew my interest rate would increase at the year-seven adjustment. So I refinanced into a 15-year fixed rate at 2.75%. That was the right move.

What if you have an ARM today and you plan on keeping that mortgage long-term? I'd think about refinancing in the next six to eight months. Most people should be able to get a fixed interest rate lower than the fully indexed rate on either a LIBOR ARM or a SOFR ARM.

Thinking of getting a new ARM? Do it now before the margins increase with the introduction of SOFR.

All this looking like gibberish and need personalized numbers/recommendations? Give us a buzz. We're here to help!