Just because something is printed on official and legal documents doesn't mean it's accurate. APR disclosures for adjustable rate mortgages are just big fat guesses. Let's find out why.
Supposing you’re a lender with a 5/1 hybrid ARM product with these parameters:
Start rate: 4.00% Index: 6-month LIBOR, which is at .41%
Margin: 2.50% Introductory period: 5 years (60 months)
Adjustment cap: 2.0% (that’s the most the rate can increase in any one year
Lifetime cap: 10% (that’s the highest the loan can go over its life)
The loan will be fixed at 4.00% for five years, and then its rate will adjust to….what? A “best case” scenario would have the LIBOR drop to its historical best of .0388 and stay there for 25 years. In that case, the interest rate would drop to 2.888% at Year 6 and stay there! That’s pretty unlikely, given that the index only achieved this value for a single month in its entire history!
The “worst case” scenario would have the rate increase to 6.00% in Year 6 (because rate increases are capped at 2.0%), 8.00% in Year 7, to the lifetime maximum of 10.00% in Year 8, and stay there for the next 23 years! That’s also unlikely, but it is possible. With a 2.5% margin, the index would have to hit 7.5% or higher to get you a 10% rate. And it’s done that 16 times since 1989.
However, the median value of the index is 4.25 percent. That would give you a rate that increased to 6.00% in Year 6 and then 6.75% for years 7 through Year 30. Yes, it’s still a guess, but probably a lot more accurate than either of the first two.
So, that’s what lenders do, right?
Here’s How Lenders Calculate APR
Your lender discloses APR assuming that the rate is 4.00% for Years 1-5, but then it ASSUMES that the rate will adjust five years from now using TODAY'S index and margin. And then it assumes that rate won’t change for the remaining 25 years! So you’d get a rate of 2.91% (2.5% margin plus .41% index) for Year 6 through Year 30!
What does this mean for you? That you can use APR to choose between two similar ARMs (5/1 to 5/1, 3/1 to 3/1, etc.). However, you’ll want to use the same calculator because different lenders or Web sites may calculate the ARM APRs very differently. And don’t make the mistake of assuming that the APR disclosure you get is remotely based in reality.