Do You Have an ARM (Adjustable Rate) Mortgage? Time to Review?
Adjustable rate mortgages (ARMs) move up and down in popularity depending on the level of interest rates. Many choose an ARM such as a 7 year or a 5 year because they don’t expect to be in a home for a long period. These two loans have a period where the interest rate is fixed (7 years or 5 years, respectively). After that initial period, the rate may reset every year. Alternative version have only one adjustment. That adjustment applies to the balance of a 30 year term. For example 7/23 or 5/25. Read Winning Mortgage, Winning Home for more information on ARMs and the appropriate use.
The benefit of these two ARMs come from usually achieving a rate ½% to ¾% lower than the rate on a 30 year loan for the initial fixed period. This provides an interest rate comparable to a 15 year fixed rate loan and lower than a 30 year fixed rate loan. The loan also provides for payments on a 30 year schedule. Borrowers avoid the higher payment requirement of a 15 year mortgage. A 15 year mortgage would have a monthly payment about 50-75% higher than a 30 year mortgage.
As an example, assume a loan of $200,000. A 3.000% 30 year fixed rate loan requires a payment of $843 per month. A 2.375% 15 year mortgage requires a payment of $1322 per month despite the lower interest rate. A 7 year ARM couples the lower 2.375% rate with the longer 30 year payment schedule. This results in a payment of $777 per month. This provides the best of the rate and payment schedules for a lower payment overall. ARMs aren’t for everyone.
Reference Rates and Pending Changes
All ARMs have a reference rate in the loan. The reference rate is what happens after any period of a fixed rate ends. There are dozens and dozens of different reference rates. The spread is the amount over the reference rate at which the loan will be reset. So a loan with a LIBOR 1 year reference rate and a spread of 2.25% would reset on the next interest rate change date to the current 1 year LIBOR rate as published + 2.25%.
Currently, the LIBOR reference rate for a 1 year term is .281%. If that loan reset today, the total rate would be .281% + 2.25% for a total of 2.531%. This is usually rounded to the nearest 1/8% and the result would be a rate of 2.5% for the next fixed period, usually 1 year. If the loan was a 7/23 loan, the reset rate would be good for the next 23 years, for a total of 30 years of a term.
Why review now? At the end of 2021, LIBOR, a very common reference rate will no longer be used. After a transition period, a different reference rate will be substituted. Your loan document which references LIBOR provides for the lender to use a different rate if LIBOR is no longer available. The lender can choose the reference rate. Take a peek at your loan documents if you have an ARM. When is the next reset date? Is it in 2022 or later? Perhaps it’s time to ask the lender what the new reference rate to be used is or time to refinance to a long term fixed rate loan if you plan to stay in the home for more than a few years.
If you have an ARM based on LIBOR, you may or may not receive a notice from your lender about the transition and change of reference rate. Lenders are not required to provide this until your rate is actually scheduled to change.
LIBOR Transition
The largest loan buyers, Fannie Mae and Freddie Mac have already began transitioning by not buying certain ARMs. This has led to a short lived dearth of ARMs available. Those available have a higher initial rate than normal based on the uncertainty. This should abate later in 2021 and result in a more normal ARM market. The transition has begun and the two timelines for Fannie Mae and Freddie Mac provided below outline the timing.
What does it mean that the March 5, 2021 announcements triggered a “Benchmark Transition Event?” March 5, 2021 announcements by various agencies constitute a “Benchmark Transition Event” for all USD LIBOR settings. This does not require an immediate transition to a non-LIBOR benchmark. It did not trigger notice requirements (other than perhaps for certain business loans). The actual transition from LIBOR to an alternative reference rate will not occur until LIBOR actually ceases. Currently, the transition occurs on or immediately after June 30, 2023 (the “Benchmark Replacement Rate”).
Timelines
