 Personal Finance PowerPoint Presentation. Adjustable Rate Mortgage or ARM. Get ready to get financially fit by practicing personal finance. Most of this information can be found at Investopedia Adjustable Rate Mortgage. What happens when your interest rate goes up, which you can find online. Take a look at the references, resources, continue your research from there. This is by Donna Foscaldi, updated February 8th, 2022. Adjustable Rate Mortgage, what happens when your rate goes up? So clearly if we're in a home purchasing process, typically we can't put just simply the cash down upfront, but need to take some kind of loan. We need some kind of financing. The typical loan we think of is the 30 year fixed loan, which I would think of as the baseline type of loan, one which we will make comparisons to. One type of comparative loan you could think about is of course the adjustable rate loan, where we have the risk going from the lender more on over to the borrower as changes in the market going forward could have an impact on the rates. We gotta take that into consideration. So adjustable rate mortgages or ARMS can say borrowers a lot of money in interest rates over the short to immediate term. So obviously when you're thinking about this situation, typically the reason you would get an adjustable rate mortgage is because you would have a lower interest rate upfront. Just consider why this would happen. Remember we're in a business negotiation. This is a business setting. There's two people involved. We're not really talking about the seller here. We're talking about the buyer and the bank. And then the buyer takes the money and then we could talk about the seller and the buyer. But we got A and B here in the negotiation. We're thinking about the bank or the lender or the financial institution and the buyer. And clearly the bank wants to make the loan because they wanna make interest on the loan. However, they gotta mitigate the risk involved with the loan as well. Therefore, if they're gonna fix the rate, meaning if the rate's not going to change, that's gonna put more risk on the bank because if there's a rate change going forward into the future, if rates go up in other words, then the bank has now has a loan out there at a rate that's below the market rate possibly. So if they're able to lower the rate, then they can give you a lower upfront rate because they'd be taking on less risk. So it's all about the balance between the risk and the benefit. So if you take on more of the risk by saying, I'm gonna allow you to adjust the rate in some way, dependent upon some future circumstance, perhaps for example, changes in the market rates, then the bank has less risk and you'll be able to get lower rates typically upfront, but you have then the capacity or the possibility that rates will go up in the future that you need to take into consideration. It gets much more complex to do longer term plan and calculations that you wanna make sure that you're aware of. So but if you're holding one, when it's time for the interest rates to reset, you may face a much longer monthly mortgage bill, a much higher mortgage bill. So clearly if the rates then adjust and you're subject to the adjusting rates and the adjustments happen in an increase, an increase, then of course, you'll have higher bills at that point. That's fine if you can afford it, but if you are like the vast majority of Americans an increase in the amount you pay each month is likely to be hard to swallow. So clearly most people are trying to get as much house as they can. And if they're doing it with an adjustable rate mortgage, they're probably paying close to the top that they can pay at that point, any increase in the mortgage, especially a substantial one, could be detrimental to the budget. So what is an adjustable rate mortgage? Consider this, the resetting of adjustable rate mortgages during the financial crisis explains why in part, so many people were forced into foreclosure as had to sell their homes in short sales. So clearly if a lot of people are in adjustable rate mortgages and there is a decrease, I mean, if there's a decline in the economy, which or an increase in the interest rates, then that could force large amounts of people that weren't like prepared for that to happen into foreclosure. So that's of course why the banks, you would think would be in a situation where they would want to mitigate the risk and they might be more adverse or skeptical of adjustable rate mortgages or might have other conditions in play. But remember, anytime you have the third parties into the market, which includes government intervention, for example, selling things on a secondary market to quasi-government entities like Fannie Mae and Freddie Mac, that distorts the whole picture. So just because you can get a particular loan, in other words, doesn't mean of course that you should get the loan. And even if the benefits are there in order for you to allow you to qualify for a loan, that you want to make sure that you're taken into consider the factors that could happen in the future, which is more difficult when you're looking at an adjustable rate mortgage. While the arm has gotten a bum wrap, it's not a bad mortgage product provided borrowers know what they are getting into and what happens when an adjustable rate mortgage resets. So there's nothing really wrong with an arm, although it takes on more risk. Now at this point in time, it seems fairly clear that interest rates are on an uptick. How far are they gonna be on an uptick? We don't really know. So you can kind of get a general idea in terms of whether the rates are going up or not and whether an arm would be a good risk to take or not. But whenever you're taking about a negotiating situation between A and B, in this case, the bank and the borrower, as long as both people are making decisions with all the information necessary to make an appropriate decision, that would be good. But in many situations, and again, when the government gets involved, oftentimes if the bank can offload some of the risk on their end to secondary markets or something like that, then the bank has an incentive to do more of those kind of riskier types of loans and the borrower might not have all the information that's gonna be this longer term information to make the best decisions. So there's nothing wrong with an arm, but the borrower has to be, you gotta be an informed borrower to determine whether or not it's worthwhile to take an adjustable rate loan. And again, we can't really depend on the financial institution, even if we feel like they're being enforced by the government in some way to provide these types of loans. That doesn't mean it's good. That means you have the opportunity or the possibility to take out that loan and then you wanna do your own research on it to see if it would be a beneficial thing to do or not. Interest rate changes with an arm in order to get a grasp on what is in store for you with an adjustable rate mortgage, you first have to understand how the product works. With an arm, borrowers lock in an interest rate, usually a low one for a set period of time. So you're gonna say, okay, if we go from a 30 year fixed to this arm, we're able to give you a lower rate than we would give you for the 30 year fixed and I used a 30 year fixed as the standard, right? That's like, if you had all the boxes checked off, I got good credit. I've got enough revenue that the bank is okay with that. And I have debt to income ratio is good, 30 year loan. Then that would be my baseline starting point. And then when we deviate from that, that can give you some kind of judgment to compare it to kind of where the market is at that baseline. So obviously if you're at the 30 year fixed and then you're saying, I'm gonna go to an arm, an adjustable rate, you would expect everything else equal that you would have a lower rate than the 30 year fixed. Now, some of the reason you might be going into an arm is because you might not have everything, all the boxes checked off. But again, that's kind of like the baseline. When that timeframe ends, the mortgage interest rate resets to whatever a prevailing interest rate is. So after whatever that timeframe is, then you gotta take a look at the market and the rates gonna reset and you don't have any control over it at that point. So you better be ready. So the initial period in which the rate doesn't change ranges anywhere from six months to 10 years, according to the Federal Home Loan Mortgage Corporation or Freddie Mac. Some arm products, the interest rate and borrower pays and the amount of the monthly payment can increase substantially later on in the loan. So clearly there could be a substantial increase depending on market conditions at that point. And obviously the bank could give a, the sweet loan amount at the beginning if they think that they're gonna be able to get the benefit back in the long run after that timeframe has passed. Because of the initial low interest rate, it can be attractive to borrowers, particularly those who don't plan to stay in their homes for too long or who are knowledgeable enough to refinance it if interest rates go up. So if you're savvy on the purchasing side of things and you're saying, hey, look, I'm just buying this home for a couple of years and then I'm gonna do something after that couple of years noting that worst case scenario, you could actually have the housing market go down and then you kind of be locked in at that point in time. So you're still taking on a substantial amount of risk if that were the case, but that would be more attractive to get an arm in that case. Also, when you see the change happening to the rates, then you could refinance at that point, possibly locking the rate at that point in time. That would be an option if you had the capacity to do that, if you had the capacity to act fast, but again, you're kind of judging the market in order to do that. If you're in a situation where you expect the rates are not gonna go up, the rates are gonna stay the same or possibly go down, then you're betting on the idea that the rates are gonna go down. Probably not what most people are betting on now at this point in time. Now most people are betting on the rates going up at least in the short run and possibly going up into the longer run depending on your trust on the Federal Reserve and the government and so on. So in recent years, and the market conditions, in recent years with interest rates hovering at record lows, borrowers who had an adjustable rate mortgage or adjusted didn't see too big a jump in their monthly payments. So we've had a fairly decent timeframe where the rates have been kind of held constant. Now you might argue they were artificially held constant. And again, anytime something happens which often happens in the home market, housing market, you have these longer time frames, there's still business cycles, there's ups and downs, but they tend to be longer and you have government incentives in there to try to keep the status quo for a long time. So they've been keeping the interest rates pretty low pretty much artificially for a long time. That means at some point, if something hits it, it's kind of like the immune system is down and they don't really have as much recourse because the government is already doing everything they can to do something. So at this point in time, we might have hit a point where it looks like the government doesn't have the ammo anymore to keep rates artificially low but that's just my perspective. It's possible that they do and things will, the other argument would be every 10 years or so people get the argument of, well, things have been fixed, things are good now, the government has figured it out, we're never gonna have a decrease in the market again, interest rates will never go above so much percent because economics has been figured out, but and then it's disproved every 10 years or so. So we'll see what the trend happens in the future. So in any case, but that could change depending on how much and how quickly the Federal Reserve raises its benchmark rate. So know your adjustable rate period in order to determine whether an arm is a good fit, borrowers have to understand some basics about these loans in essence. The adjustment period is the period between interest rate changes. So take for instance an adjustable rate mortgage that has an adjustment period of one year. The mortgage product would be called a one year arm and the interest rate and thus the monthly mortgage payment would be changed once every year. So then they would lock you in for basically a year and then the year had passed, they make the adjustment, whatever that adjustment is, it might not be, then they make the adjustment on a yearly basis. So if the adjustment period is three years, it's called a three year arm and the rate would change every three years. So that would mean of course you'd have three years before they then adjust the rate in that case. Notice that if you're talking about shorter timeframes like a one year adjustment, that would you would think be more taking more risk away from the bank than a three year. So once you start thinking about what kind of adjustable arms are in there, you can have different factors on the adjustable arm. If you have a three year adjustable arm, well now you've got a longer cushion of time which you're somewhat more stagnant where you can depend on and therefore, whereas the bank is taking on the risk during that three year time period if rates were fluctuating substantially within that range. Whereas if you're talking about a one year, that means that you're only getting that static timeframe for one year and the bank again is taking on less risk at that time because they get to re-up to whatever they think is reasonable based on market conditions every year in that case. So that would mean if you were comparing the one year to the three year, it's possible that the bank would give you a better rate on the one year arm than the three year arm. So now you've got different levels of risk versus reward and the interplay between risk versus reward less risk to the bank, the more favorable terms they'll be able to give. So more risk that you take on the more favorable terms the bank is gonna be able to give in general. So there are also some hybrid products like a five one year arm which gives you a fixed rate for the first five years after which interest rate adjusts once every year. So now you get that five year timeframe upfront while I'm fixing it, I'm locking it down for five years and then after that point in time you could have that substantial difference depending on what if there's substantial change in the market. So understand the basics for the rate change in addition to the knowledge of how often your arm will adjust, borrowers have to understand the basis for the change and the interest rate lenders base arm rates on various indexes with the most common being the one year instant maturity treasury securities, the cost of funds index and the prime rate. So meaning these are gonna be rates that should give you kind of a broad indication of market conditions. So those are gonna be like those, the market rates that they're gonna have to base it off on. In other words, you might say, well, how are they gonna know what the rate should be at something? Do they just make it up at that point? No, they're gonna go on some kind of market rate that isn't under their specific control and then base it off of that rate, right? That would be the general idea. Before taking out an arm, make sure to ask the lender which index will be used and examine how it has fluctuated in the past. So you can try to think of what the fluctuations have been. You're probably not gonna be able to guess exactly what's gonna happen in the future, of course, but you might get a general idea of what's going on in the market. Like right now, again, you would expect rates to go up, they're kind of on the increase. Again, some people will argue that it's gonna be a short-term increase and the Fed will stop it down and the economy is strong and it'll be fixed going forward and other people are less, have a little less faith in the process but we don't really know, you don't really know, right? So if you think you're gonna get it exact, you're probably not because you'd be out guessing the market which is a difficult thing to do. So you want to basically try to just mitigate your risk when you're making your decision-making process, taking it into consideration adverse conditions and trying to see what would happen and say like a worst case scenario, would you be able to deal with that? How likely is that to happen and so on? So avoid payments, shock. So one of the biggest risks arm borrowers face when their loan adjusts is payment shock when the monthly mortgage payment rises substantially because of the rate adjustment. So obviously if there's a big jump up in your mortgage payments, then apparently they call that payment shock. I had a case of payment shock. It was terrible. This can cause hardship on the borrower's part if they can't afford to make the new payments. So that clearly would be a problem. To prevent sticker shock, which is something I get all the time because I'm allergic to that glue that they put on the back of the stickers, it puts me into shock. But in any case, to prevent sticker shock from happening to you, be sure to stay on top of the interest rates as your adjustment period approaches. So you're gonna be saying, okay, when's that adjustment period happened? I'm gonna brace myself for the sticker shock, be ready budget plan. And then so you know what's happening. According to the consumer financial protection board, the CFPB mortgage services are required to send you an estimate of your new payment. So they're gonna say, hey, here's your payment. It's coming, the payment is coming, be ready. So if the arm is resetting for the first time, that estimate should be sent to you seven to eight months before the adjustment. So you get the seven to eight month time period to brace yourself. So if the loan has adjusted before, you'll be notified two to four months ahead of time. What's more, with the first notification, lenders must provide options that you can explore if you can't afford the new rate, as well as information about how to contact a HUD approved housing counselor. So knowing ahead of time what the new payment is going to be will give you the time to budget for it, shop around for a better loan or get help figuring out what your options are. So you might say, okay, this is happening at this point. Do I have, can I refinancing or something? What are my options? What do I do? I'm gonna sit here and wave with my arms wildly and scream at the wall or you can try to refinance or something like that or budget or take some action. So the bottom line, taking out an adjustable rate mortgage doesn't have to be a risky endeavor as long as you understand what happens when your mortgage interest rates reset. So unlike fixed mortgages, mortgages where you pay the same interest rate over the life of the loan with an arm, the interest rate will change after a period of time. And in some cases, it may rise significantly. So again, the idea would be that you're shifting the risk from the bank to the borrower, you're lowering at least the first payments in order to do so. It got a bad rap. These arms did because they were part of the mortgage downturn, the housing bubble, downturn and so on. But it's not a bad thing that the loans itself, it's just that obviously both sides of the table need to understand the benefits and the risks involved with it in order to make an appropriate type of decision. And again, if there's outside incentives, governments for example, putting in incentives programs that clearly incentivize banks to not be as transparent or to kind of push those more risky loans then the buyers might not have as much information to be going into the negotiation properly. But if you do have that information, if you're going in with your eyes open and you're saying, hey look, this is what I plan to be doing. I'm taking on more risk. I know I'm taking on more risk and I have a plan for it. That's why I'm doing it. Then it could be a good option. So knowing ahead of time how much more you'll owe or may owe each month can prevent sticker shocks. So don't do that sticker shock and don't do those sticker, that glue on the back of the stickers. Just keep it away, that glue, because it's so more important, it can help ensure that you are able to make your mortgage payments each month.