Understanding Adjustable Rate Mortgage Loans

ARM Basics

The Adjustment Period
The period between interest rate adjustments is called the adjustment period. The adjustment period can be monthly, semi-annually, annually, etc.

The Index
The margin is the number of percentage points added to an index to calculate the fully indexed rate. Financial institutions begin with the current index figure and add a margin to determine the interest rate on an ARM loan. Margins vary depending on the loan product, but once selected the margin remains constant for the life of a loan. However, the fully indexed rate increases and decreases depending on the movement of the current index rate. An example calculation method is displayed below:

Lookback Period
When applying an index for adjustment purposes, HomEq follows the specific language of each borrower's Note/Rider. The Note/Rider will specify the exact number of days prior to the interest rate change date that must be used for the adjustment index. This is called the "lookback period". The lookback period, subtracted from the interest rate change date, becomes the "index selection date."

In calculating the borrower's new interest rate, the most recently published index value is used. The borrower's Note/Rider will specify the exact date or number of lookback days prior to the interest rate change date to use. Since the interest is paid in arrears, the payment change date is effective one month after the interest rate change date.

Rate Adjustments and Caps

The Initial Rate
Many lenders offer lower initial starting rates at origination on ARM products. Rates depend on the loan product selected, since the initial rate is lower than the fully indexed rate, it is called a "discounted rate".

Rate Caps
To provide borrowers with security and reduce some risk ARMs have rate adjustment caps. Rate Adjustment Caps limit the increase or decrease in the loan interest rate over a period of time, depending on the loan product and index chosen. Caps are established in the Note/Rider.

Periodic Rate Adjustment Cap
The maximum amount that the interest rate can increase or decrease at each adjustment period is called the "Periodic Rate Adjustment Cap". Many products have periodic rate caps that are different based on the period. For example a loan could have a 1% periodic cap on the 1st change and then a 2% periodic cap on the 2nd change. This information is in the Note/Rider.

Annual Rate Adjustment Cap
The Annual Rate Adjustment Cap is the maximum percentage that an interest rate may increase or decrease during each year (from the interest start date at loan origination). This cap is based on the rate at each anniversary date of the loan. This cap applies in addition to and supersedes any periodic cap.

Ceiling and Floor
In addition to caps, ARMs may have additional adjustment protection known as ceiling and floor rates. The ceiling and floor are the maximum or minimum that a borrower's interest rate can reach over the life of the loan. No matter how the interest rate changes for the specific index, the interest rate a borrower pays cannot exceed the ceiling or fall below the floor specified in the Note/Rider. This cap supersedes any periodic or annual cap.

Conversion Options
ARM loans may allow options to convert them to a fixed rate loan based on a pre-determined formula, during a given time period. For example, some 1-year Treasury bill adjustable rate mortgages may be converted to a fixed rate during the first five years on the adjustment date. This means that the loan could convert during the 13^th, 25^th, 37^th, 49^th and 61^st months of the term. The Note/Rider will state if the ARM loan is convertible to a fixed rate of interest.

Interest Rate
At each rate adjustment, the interest rate may adjust and the resulting figure is typically rounded. The rounding factor, if any, is stated in the Note /Rider.

Calculating the New Payment

The New Rate
Because most ARM loans begin with an initial discounted interest rate, the first adjustment, regardless of changes in the index value, will typically result in an interest rate increase. The parameters are set forth in the Note/Rider.

The New Payment
The projected Unpaid Principal Balance (UPB) and the remaining scheduled term that is in line with the effective date of the interest rate change known at the time the ARM adjustment is being processed will be used in calculating the new principal and interest payment.

The remaining scheduled term associated with the effective date of the new rate is always used in calculating the new payment amount. The new payment amount will reflect the amount of money needed to pay the loan in full over the remaining term. This means that principal curtailments do not shorten the term of an ARM loan, but may reduce subsequent payment amounts.

The following data associated with the due date of the new rate is used to calculate the new payment.

• Unpaid Principal Balance (UPB)
• Remaining Loan Term
• New Interest Rate

Borrower Notification

ARM interest rate and payment adjustment notices are sent to the borrower in accordance with the Note/Rider. These notices should be mailed prior to the adjustment taking place but no later than 31-25 days prior to the payment change date depending on the governing instrument.