ARM – A Commercial Adjustable Rate Mortgage: An explanation of rate escalations with an ARM (Adjustable Rate Mortgage)
A Commercial Adjustable Rate Mortgage (ARM) is a commercial loan where the interest rate on the note is periodically adjusted based on the index the note is written with. There are a variety of different indexes used, but the commercial lender will ultimately determine which index will be offered with each commercial loan program. This is done to ensure a steady margin for the lender, whose own cost of funding the loan will usually be related to the index. Consequently, the required payments made by the borrower may change over time with the varying interest rate (alternatively, the term of the loan may change). - This is not to be confused with the graduated payment mortgage, which offers varying payment amounts but a fixed interest rate.
Other forms of mortgage loans include interest only mortgages, fixed rate mortgages, negative amortization mortgages, and balloon payment mortgages. The main idea behind an ARM is that an adjustable rate mortgage transfers part of the interest rate risk from the lender to the borrower. They are usually utilized when unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate falls and loses out if interest rates rise.
All adjustable rate mortgages have an adjusting interest rate tied to an index. Some common residential and commercial indices in the United States are:
- 11th District Cost of Funds Index (COFI)
- London Interbank Offered Rate (LIBOR)
- 12-Month Treasury Average Index (MTA)
- Constant Maturity Treasury (CMT)
- National Average Contract Mortgage Rate
- Bank Bill Swap Rate (BBSW)
The most important features of commercial ARMS are:
- Initial interest rate – This is the nominal rate set at the beginning of the loan.
- The adjustment period – This is the period of time an interest rate is set to remain unchanged, usually monthly or annually. The rate is reset at the end of this period, and the monthly payment is increased or decreased accordingly.
- The index rate – This is the rate of the index tied to the commercial loan. As the index changes, the rate will change accordingly.
- The margin – This is the spread between the index and the percentage points charged by the lender to fund and carry the loan. To calculate the nominal rate you add the margin to the index rate.
- Interest rate caps – These are the limits of how much the interest rate can fluctuate or change at the end of each adjustment period. There are usually floors and ceilings set to ensure a certain return is established.
- Discount points – Percentage points paid by the consumer or credited by the lender to reduce the interest rate below the original nominal rate.
- Negative amortization – This means that instead of reducing the amount of principal owed, you are actually increasing the amount by paying less than the accrued interest.
- Conversion – This is an agreement stated within the language of the note giving the borrower the option to convert the commercial ARM to a fixed-rate mortgage at certain designated times.
- Prepayment penalties – certain fees or penalties charged to a borrower if the loan is paid off early. These are usually accompanied with commercial ARMs to guarantee a specific return to the commercial lender or investor for a certain period.
By Mortgagefit Community
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