How ARMs work

An adjustable-rate mortgage has an interest rate that can change at predetermined intervals. These adjustable-rate mortgage products can vary in several ways including the amount the rate can increase or decrease at each adjustment, the frequency of rate adjustments, the maximum cap on adjustments, and the length initial fixed-rate introductory period.

An ARM has two important features: the margin and the index. The margin is a specified number of percentage points that never changes, while the index is an interest rate that moves up or down with market conditions. The index plus the margin is the interest rate you pay. Margins are predetermined in your loan agreement and the index is published by an independent financial institution. There are various rate indices that are used as a benchmark for many forms of adjustable-rate financial products. Common indices include the prime rate as reported by the Wall Street Journal bank survey, Fed Funds Rate and the Secured Overnight Financing Rate (SOFR) published by the Federal Reserve Bank of New York.

Why ARM indexes are changing

For years, most adjustable-rate mortgages have used a benchmark rate index called LIBOR – London Interbank Offered Rate. In recent years, LIBOR has been phased out in a coordinated international effort and is being replaced by SOFR. LIBOR was criticized for being too heavily influenced and manipulated by the rate-setting banks. To reduce the manipulation and create an index based more closely on the rates US Financial Institutions are charging each other SOFR was adopted as a replacement. When the change is happening: The transition to SOFR loans has already begun. Fannie Mae and Freddie Mac won’t buy Libor ARMs until around September of 2020 at which time many banks stopped offering LIBOR-based ARM products. The Federal Housing Administration, Department of Veterans Affairs and Department of Agriculture were scheduled to stop insuring or guaranteeing new Libor ARMs at the end of 2020. As of early November 2020, Libor ARMs were still available for jumbo mortgages, but jumbos will have to move away from Libor by the end of 2021.

Shopping for a SOFR ARM

Adjustable-rate mortgages can be advantageous for borrowers who have a shorter-term outlook for the home they are buying. According to the National Association of Realtors, the median homeownership duration is 13 years. Homeowners on the shorter end of that spectrum who may need to upgrade/downgrade or move for work within a 5-10 year period could capitalize on the lower introductory rate of an ARM product. Many ARMs have an initial fixed-rate introductory period of 5, 7, or 10 years which means their interest rate will be fixed for the majority of their period of homeownership. That initial fixed rate could offer sizeable savings in comparison to a 30 year fixed mortgage product.

What will happen to existing Libor loans?

All ARM contracts have language that allows lenders to find a replacement if the loan’s index goes away. Eventually, existing Libor-indexed ARMs will be switched over to SOFR. The timing has yet to be worked out, depending partly on when British regulators call it quits on Libor. On this side of the Atlantic, regulators have stressed the need for an “effective transition.” The lender must provide notice 60 to 120 days before the first payment under the adjusted rate.

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