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June 6, 2005
Adjustable rate mortgages (ARMs) are becoming
increasingly popular with borrowers, and the cost of borrower ignorance about
ARMs is growing with it. Every day I encounter misperceptions that have led to
bad decisions, or are about to.
What Is the
Fully-Indexed Rate?
To avoid getting trapped into a bad ARM, it
is very useful to understand the difference between the interest rate and the
fully-indexed rate (FIR).
The ARM interest rate is the rate you see: it
is the rate quoted by the loan provider, and the rate shown in the media. It is
the same as the rate on a fixed-rate mortgage, with one difference. The ARM rateholds only for a specified initial period. That period can be as short as a
month, and as long as 10 years. At the end of that period, the rate is adjusted.
The FIR is the rate you don�t see. It is
never quoted, never shown in the media, and is not a required disclosure. Yet it
is the major indicator of what will happen to the rate at the end of the initial
rate period.
If the initial rate period is long and the
borrower expects confidently to be out of the house before it is over, the FIR
is unimportant. But if the initial rate period is short, or if there is a
reasonable probability the borrower will still have the mortgage when it ends,
the FIR is critically important to the borrower.
The Fully-Indexed
Rate on an Option ARM
The flexible payment or "option" ARM, which
has been growing in popularity, has an initial rate period of one month. It is a
favorite instrument of hucksters because they can advertise rates as low as 1%.
They don�t bother to mention that this rate holds only for the first month. The
FIR, which provides the best clue as to what the rate may be in the 359 months
that follow, is seldom volunteered.
The FIR is the current value of the rate
index used by the ARM, plus a margin which varies from one transaction to
another, but stays the same through the life of any one ARM. For example, a
widely used index on monthly ARMs is COFI, standing for cost of funds index. If
the current value of COFI is 2.5%, as it was in April, 2005, and if the margin
on a particular loan is 3%, the FIR on that loan is 5.5%.
Why the
Fully-Indexed Rate Is Important
The FIR is usually the best prediction of the
rate at the first rate adjustment � which is month 2 on a monthly ARM. If the
index does not change between month 1 and month 2, the rate in month 2 will be
the FIR.
That is important information for the
borrower to have. If you are choosing between two ARMs that are otherwise the
same, you take the one with the lower FIR.
How to Find the
Fully-Indexed Rate
If two ARMs use the same index, you only have
to compare the margins because the index values will be the same. I don�t advise
using this shortcut, however, because sometimes indexes with the same names are
different. For example, the loan provider may tell you that the index is
"Treasury" or "Libor", but there are several different indexes that fall under
each of these headings.
Even if the index is the same,
furthermore, lenders may define the "current value of the index" differently.
While some indexes (such as COFI) are only available monthly, a number of
Treasury and Libor series that are used as indexes are published monthly, weekly
and daily. If one lender uses the latest monthly average while another uses the
latest weekly average, their FIRs won�t be comparable.
To make sure two FIRs are comparable, proceed
as follows:
1. Ask the loan provider for the margin -- in
writing. You don�t want any nasty surprises at the closing table.
2. Ask the loan provider to identify the
index used from a list that you give him. Copy the list shown at
ARM Indexes.
3. Find the most current value of the index
yourself. (The web page cited above shows on-line sources for all the indexes
listed there.) Just remember that if you are comparing ARMs with different
indexes, the period used should be the same. They should both be monthly values
for the same month, weekly values for the same week, or daily values for the
same day.
Yes, you could ask the loan officer to do
this for you, it is his job, after all. His interests may not coincide with
yours, however, so if you want to be sure it is done right, do it yourself.
Copyright Jack Guttentag 2005
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