How Does An Adjustable Rate Loan Really Work?

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By PETER ROSENTHAL, President
V.I.P. Trust Deed Company

Q: I have owned several pieces of real estate for over ten years. On my home I have a fixed rate loan, and both my rental properties have adjustable rate loans. I have had these loans for a few years and am in the process of refinancing one of them. Frankly, I don’t understand how adjustable loans “really work” and hope that you can clarify that for me, including a definition of the terms, margin and teaser rate.

A: That is an easy assignment. An adjustable rate mortgage (ARM) adjusts up or down on a regular basis. Usually the rate and payment are adjustable, with certain limits on the amount of interest or payment increase/decrease in any one adjustment period. The adjustment period can be yearly, quarterly or even monthly, depending on the type of plan. The actual rate adjusts up or down using an “INDEX” and a “MARGIN” or “SPREAD.” Here’s how it works.

The most widely used index in California is the “11th District Cost of Funds.” The index could be a Treasury bill index, the prime rate or perhaps Libor. I will not go into details on these indices other than to say all of these indices are commonly used on California loans and can easily be ascertained by reading financial periodicals or contacting a broker or mortgage company. Let’s take a look at the 11th District Cost of Funds which is, theoretically, a bank or savings bank weighted cost of funds, including checking accounts, savings accounts, certificates of deposit, etc.

As I write this column the 11th District Cost of Funds is 4.519%. Let’s round that out to 4.5%. Six months from now, this index may be 4.25% or 4.7%. Here’s how your adjustable works. When your loan was taken out, you were quoted the index type and margin. This could have been quoted as 11th District plus 2.5%. This means that your actual or true adjustable rate is calculated by adding the 11th District Cost of Funds (4.5%) plus the margin (2.5%). The total of these two is 7%. The margin is also referred to as the lender’s spread. In this example, the lender is always collecting interest at 2.5% above the 11th District Cost of Funds, which increases or decreases.

If the index rises to 4.7% in six months, your adjustable may increase to 4.7% plus 2.5% = 7.2%. If the index falls to 4.25%, your new interest rate would be 4.25% plus 2.5% = 6.75%. This assumes that these are the new rates on a regular adjustment date. This is very simple, as the index rises and falls but the margin or spread stays the same. The actual interest can then easily be figured by adding the two together.

Now comes the marketing “teaser.” The teaser rate is an inducement or, in fact, a “loss leader.” This great rate is intended to tease you, snare you, fool you, or at worst defraud you if you really believe in the tooth fairy. At the time the new loan is booked, the 11th District index might be 4.5% and the margin 2.5%. The actual or true rate is therefore 7% using the above simple math. However, you may be quoted an initial or starting rate of 4% or perhaps 2.9%. Yes, your lender will lend you money for an initial period at the lower rate, but the rate will then quickly adjust using the math above. Teaser rates are great if they are locked in for six months or a year and you are planning to sell the property in a year or two. Teaser rates are simply loss leaders to get you locked into a loan that is usually at a significantly higher interest rate.

If you like teaser rates I will propose one for you. I have a lender who will lend you money at an initial rate of 1.9%. If you are sharp you will then ask, “How much can this rate change on any adjustment period?” I will still tease you and tell you it can only change one tenth of one percent on any adjustment period. I am hoping that you won’t ask me the next question: “How often are the adjustment periods?” If, unfortunately, you ask me that question, I guess I will have to be truthful: “It adjusts HOURLY.” Remember, liars can figure and figures can lie.

Peter Rosenthal
VIP Trust Deed Company