Adjustable-Rate Mortgages: What You Need To Know About a Reset

by Meiling Hunter
CMR Columnist

From 2004 through 2006, more than $2.28 trillion worth of adjustable-rate mortgages (ARMs) were originated. ARMs' initial rates began resetting to higher ones in 2007, contributing to record numbers of home foreclosures. In 2008 approximately $250 billion in ARMs are due to reset--in addition to the $370 billion that reset in 2007.

What Is a Home Loan "Reset"?

ARMs feature an introductory period in which the interest is fixed at a lower than market rate. This period can run from 3 months to 10 years depending on the loan. When an ARM resets, the rate is adjusted according to the terms of the loan. This usually means an increase over the introductory rate. Your actual adjustable interest rate consists of two parts, an index that moves with financial markets and a margin that is set by the lender. The index plus the margin is called a fully indexed rate.

How Much Can My Mortgage Payment Go Up?

First, dig out your adjustable rate rider--this document should have been included with your closing documents. The rider contains your index, margin, and any caps that limit how high your rate can go. One cap might limit how high your rate can move on the first adjustment, another may limit subsequent adjustments. A lifetime cap determines the maximum rate that you can pay. Even if your fully-indexed rate moves higher, you won't pay more than your lifetime capped rate.

For example, say that your ARM is currently at an introductory rate of 4%, but it will be resetting soon. Assume that the margin on your loan is 2.5% and that your rate is based upon the one-year LIBOR index. You look up the one-year LIBOR online and see that it is at 4.5% today. If your home loan reset today, your fully-indexed interest rate would be 7% (2.5% plus 4.5%). However, you check your caps and find that your adjustment cap is 2%. So your loan can only go up to 6% this year (your 4% start rate plus a maximum of 2%). You check your lifetime cap and see that it is 6% over your start rate. So you will never pay more than a 10% rate on this mortgage.

How Do I Evaluate Refinancing?

If you have a little equity in your home (about 3%) and your loan amount is within FHA limits, you may be able to refinance into a government-backed loan. If your original loan was an FHA or VA you may be able to streamline into a new loan with no qualifying and no appraisal. This can be helpful if housing prices have been falling in your area. Those with loans that don't meet guidelines for government refinancing may still be able to lower their rates or improve the terms of their loans by refinancing. Check with several lenders for rates and programs. Online mortgage calculators can help you determine if refinancing can save you money.

If you've tarnished your credit since taking your current mortgage, refinancing might not be your answer since you may not qualify for a better rate. Try contacting a reputable credit counseling agency or HUD for help with restructuring debt, creating a budget, and improving your credit rating.

Sources: About the Author
Meiling Wong Hunter has worked in the mortgage industry for four years She graduated from the University of California, Davis, with a double major in Economics and Philosophy.

© 2008 CMR. All rights reserved.