Interest Rate Above APR on Adjustable Rate Mortgage?

May 5, 2003, revised April 8, 2004, February 13, 2011

"I’m considering a 3/1 ARM and am confused about the APR on this loan. I thought that when there were lender fees, the APR would be above the interest rate. But this 3 /1 ARM has lender fees, yet the APR is below the interest rate. Is this lender making a mistake?"

No, the APRs on many ARMs today are below their initial interest rates. This reflects an attractive feature of ARMs today, which is historically unique. More about that shortly.

Mortgage shoppers confront the APR as soon as they search for rate quotes, because under Federal regulations an interest rate quote must also show an APR. The rationale of this rule is that the APR reflects both lender fees and the interest rate, and is therefore a more comprehensive measure of cost to the borrower than the interest rate alone.

In calculating the APR, it is assumed that the lender fees are paid over the life of the mortgage, as an increment to the interest payment. In the calculation, the sum of the interest payment in every period and the fees allocated to that period, as a percent of the balance, equals the APR.

On a fixed-rate mortgage, the addition of the fees to the interest payment must result in an APR higher than the interest rate. Since the interest rate remains the same over the life of the loan, the addition of fees brings the APR above the rate.

On an adjustable rate mortgage (ARM), however, the quoted interest rate holds only for a specified period. In calculating an APR, therefore, some assumption must be made about what happens to the rate at the end of the initial rate period.

ARMs first burst on the scene in the early 80s, a period of very high interest rates. In calculating the ARM APR at that time, it was assumed that the initial rate lasted through the life of the loan. This led to absurdly low APRs on ARMs with low "teaser" rates that held for only a short period – in some cases, for only a month.

So the Federal Reserve, which administers Truth in Lending, changed the rule for calculating the APR on an ARM. It said that the APR calculation should use the initial rate only for as long as it lasted, and then should use the rates that would occur if the interest rate index used by the ARM stayed the same for the life of the loan. This is called a "no-change" or "stable- rate" scenario.

Under a stable-rate scenario, at the end of the initial rate period, the interest rate used in calculating the APR adjusts to equal the "fully-indexed rate", or FIR, subject to any rate adjustment cap. The FIR is the value of the interest rate index at the time the ARM was written, plus a margin that is specified in the note.

Here is an illustration from April, 1995. A 3/1 ARM that uses as its index the 1-year Treasury rate had an initial rate of about 7%. The value of the index at that time was 6.25% and the margin was 2.75%, resulting in a FIR of 9%. Since the rate adjustment cap was 2%, the rate could rise to the FIR after 3 years. The APR calculation was thus based on 7% for 3 years, and 9% for the remaining 27. Even if there were no lender fees, the APR would have been higher than the 7% initial rate.

A FIR above the initial rate was once viewed as the norm. It is why the initial rate was called a "teaser". On a stable-rate scenario, the ARM rate would increase at the first rate adjustment. Canny borrowers in that environment often refinanced at the end of the initial rate period, starting with a new teaser.

Flash forward to April, 2003. The same 3/1 ARM has an initial rate of about 4.75%. The value of the index is an incredibly low 1.30%, resulting in an FIR of 4.05%. The APR calculation would use 4.75% for 3 years and 4.05% for 27 years. Unless lender fees are very large, the APR will be below the initial rate.

An APR below the initial rate means that if the market stays where it is, ARM borrowers will find their rate dropping at the first rate adjustment, rather than rising. This is an anomaly, a reflection of extraordinarily low short-term interest rates. For borrowers who can deal with the risk of a rate increase, ARMs are more attractive than they have ever been before.

February 13, 2011 Postscript: It continues to be the case that APRs on ARMs are below the initial interest rate when lender fees are not high.

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