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Have an ARM? Look out for This Letter

Money.com logo Money.com 5/10/2021 Aly J. Yale
a person wearing a costume: Explainer-Adjustable-Mortgage-Rate-Letter © Money; Getty Images Explainer-Adjustable-Mortgage-Rate-Letter

Homeowners with adjustable-rate mortgages may soon receive a strange notice from their servicers. The subject? “Transition Away from the LIBOR Index for Your Adjustable-Rate Mortgage.”

If it sounds like jargon, you’re right. Though mortgage lenders have long used the LIBOR index — the London Inter-Bank Offered Rate — as the benchmark in setting interest rates for adjustable mortgages, the majority of borrowers likely aren’t aware of it.

“LIBOR has been the predominant interest rate benchmark for several decades now, going back to the ‘80s,” said Dan Fichtler, associate vice president of housing finance policy at the Mortgage Bankers Association. “It’s quite ingrained into a whole host of financial products, including adjustable-rate mortgages.”

Due to concerns regarding LIBOR’s vulnerability to fraud, however, the index is being phased out, and a new one will soon replace it. Though the exact timing of this transition is a “moving target,” as Fichtler puts it, some portions of the LIBOR will be retired at the end of this year. The rest will cease to exist by June 2023 at the latest.

When that happens, ARM rates will be based on a new index — likely the SOFR, or Secured Overnight Financing Rate, which has been recommended by the Federal Reserve as the best replacement for LIBOR.

For homeowners who already have an ARM (or a reverse mortgage or HELOC with variable interest rates), it will mean a change in how your rate is determined each time the loan resets. For those buying or refinancing with a new ARM loan, the move will change both the cap on rate increases and how often rate resets occur.

All in all, though, the transition shouldn’t be a game-changer for any borrower. As Fichtler explains, “Most borrowers aren’t steeped in the nuances of the LIBOR, and that will probably be true of whatever their new index is as well.”

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What do the changes mean for current ARM borrowers?

Adjustable-rate mortgages aren’t hugely popular, so the number of borrowers affected by this transition should be small. In February, just 1.3% of all mortgage loans originated were ARMs. A year ago, it was 3.4%.

For borrowers who do have these loans, the changes should be minimal, experts say. Most ARM contracts allow the lender to replace the benchmark index should its current one go away. They cannot, however, change basic tenets of the loan — like how often the interest rate resets, how long the loan’s term is or when payments are due.

“Existing ARM borrowers will likely see very little impact,” says Nicholas Corpuz, senior director of compliance at Brace Software, a mortgage servicing technology company.

One notable difference may be less rate fluctuation when an ARM loan resets. Because the SOFR rate is based on billions of transactions, it’s much harder to influence than the LIBOR, which is based on very few transactions.

According to Thomas Showalter, founder and CEO at mortgage underwriting platform Candor Technology, this means “large rate changes will be less frequent.”

“Small changes might be more frequent, but borrowers won’t be in for sticker shock when their loans switch benchmarks,” Showalter says. “Since the new SOFR is transaction-based, it is likely that ARM-related changes will be less abrupt and more stable over time. For SOFR to change a great deal, billions of dollars in transactions would have to clear at the new rates in order for a modest change in rates.”

There’s even a small chance that borrowers could see lower rates with the SOFR-based loans than they do on those based on LIBOR. Currently, the difference between the 1-year LIBOR and the 30-day SOFR — the two benchmarks generally used for most ARMs, is about 27 basis points, or 0.27. That’d be the difference between a 2.5% interest rate and a 2.23% one (though lenders may increase their margin to make up for lower rates).

Here’s how a paper from the Federal Reserve sums it up: “Based on historical data, the difference in average monthly payments between the two structures would be fairly small and would more frequently result in lower payments from the consumer than higher payments.”

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Does it still make sense to get an adjustable rate mortgage?

Borrowers looking to apply for a new ARM (or refinance into one) will see some additional changes. The most notable? Rate resets will come more often.

With LIBOR-based ARMs, borrowers see their interest rate change just once per year after their initial fixed rate expires. With SOFR-based ARMs, it will be every six months.

While that may sound scary (more chances for rate increases), there are actually stricter caps placed on SOFR rate increases than there are on LIBOR ones. On a LIBOR ARM, rates can increase up to two percentage points at every reset period. On SOFR loans, it’s just one percentage point.

“The maximum amount that the interest rate can go up with each reset is cut in half,” Fichtler says. “Effectively, it works out where that shouldn’t have much of an impact, if at all, on the maximum amount that a borrower would be paying. They’re just seeing the rate change more frequently.”

If you are getting a new ARM loan, be sure to ask which benchmark your rate will be based on. According to Tom Piercy, managing director of Incenter Mortgage Advisors, choosing a SOFR-based one is typically your best option.

“Take SOFR over the LIBOR-based ARMs,” Piercy says. “There are two reasons for this: First, you’ll maintain consistency and not be impacted by the changeover in June of 2023, and second, data indicates the SOFR index runs slightly below LIBOR.”

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Major change, minor impact

Since LIBOR has been around so long, the upcoming change is pretty big — at least on the back-end. For borrowers, though, the impact should be minimal.

Servicers are required to give borrowers plenty of time to prepare, too, so if you have an adjustable-rate mortgage and haven’t been notified of the change yet, expect a letter soon.

“Some, but not all, servicers have sent out preliminary announcements regarding this conversion, but there’s still plenty of time,” Piercy says. “Borrowers should expect to see more information from their servicer in the coming months.”

Once you receive a notification, you can talk to your servicer about options. According to Jeff Taylor, co-founder of mortgage technology platform Digital Risk, you may want to consider refinancing before the transition takes effect.

“Depending on the length of the ARM and the interest rate they were paying, borrowers might want to consider refinancing into a fixed-rate loan,” Taylor says. “It makes much more sense to borrow at a consistent, low interest rate — especially now when rates are much more likely to move up than down.”

Taylor says borrowers should proceed with caution, though, and talk to their servicers before making any moves.

“ARMs can have complicated rules, and some come with prepayment penalties,” Taylor says. “Anyone with an ARM that has received a letter from their lender should call and discuss their options.”

More from Money:

With Mortgage Rates So Low, Getting a Floating Rate Mortgage Might Seem Crazy. Here’s Why I Did It Anyway

Low Rates Are Putting 15-Year Mortgages — and Big Savings — Within Reach for Millions of Homeowners

Buying a House in Cash Can Save You Thousands, and You Don’t Have to Be Rich to Pull It Off

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