What it means
ARM stands for adjustable-rate mortgage, which is a home loan whose interest rate is reset from time to time. In a 2/28 loan the first number is the years of fixed rate and the second is the years that follow when the rate can move, so the two add up to the 30-year term.
After the fixed period the rate is normally set as a published market index plus a fixed margin (the lender's markup). Each adjustment can be limited by caps in the contract, which set how far the rate can rise at one reset and over the life of the loan.
These loans were common in the United States in the years before the 2008 financial crisis, especially in lending to borrowers with weaker credit. The low starting rate was often described as a teaser rate, because it was meant to attract the borrower and not to reflect the true long-term cost of the loan.
The danger is payment shock, which is a sudden jump in the monthly payment when the rate resets. Many borrowers took the loans expecting to refinance before the reset, but if house prices fell or their credit weakened, they could not, and a large number defaulted.
Regulation since the crisis has tightened lending rules. Lenders in many markets must now check that a borrower can afford the payment at the reset rate, and not only at the introductory rate, which has made the product much less common.
A borrower reading any adjustable-rate offer should ask four things. What is the initial rate, which index and margin apply after it, how high can the rate go, and what would the payment be at the maximum rate?
In practice
Real-world examples.
Example
A first-time buyer takes a 2/28 ARM at a low introductory rate because it makes the monthly payment fit his budget. He plans to sell or refinance before the rate changes in two years. A fall in local house prices blocks his plan, and he is left to pay the higher reset payment.
Example
A bank analyst models the credit losses on a portfolio of 2/28 loans. She expects defaults to peak in the months right after the reset dates, not in the first two years. She builds a schedule of reset dates to forecast cash flows.
Example
A housing counsellor meets a family who received a reset notice showing a payment increase of $450 a month. She helps them compare the options, which include asking the lender to modify the loan, refinancing to a fixed rate or selling the home. They choose a modification that keeps the rate stable for five more years.
Formula
Calculation
Monthly payment = Loan x (r / (1 - (1 + r)^-n)), where r is the monthly interest rate and n is the number of monthly payments
Suppose a borrower takes a $200,000 loan at a fixed 6% for the first two years. Monthly rate r = 0.06 / 12 = 0.005 and n = 360, giving a payment of about $1,199. After 24 payments the balance is about $194,936. If the rate resets to 10%, then r = 0.10 / 12 and n = 336 remaining payments, so the new payment is about $1,731. The increase is 1,731 - 1,199 = $532 a month, which is a rise of about 44%.Case study
Seen in the real world.
Maplewood Mortgage is an illustrative, fictional lender that sold thousands of 2/28 loans in a rising housing market. Its sales team promoted the low opening payment, and its models assumed that most borrowers would refinance after two years.
When house prices stopped rising, refinancing became difficult, and the share of borrowers falling behind jumped after the first reset. A typical $200,000 loan saw its payment rise from about $1,199 to $1,731, which was too large for many household budgets.
Maplewood's losses forced it to tighten its lending standards and to test each borrower against the reset payment. The illustrative lesson is that a loan that works only if a future event happens, such as a refinance, carries a risk that is easy to overlook when conditions are good.
Watch out
Common mistakes.
- Judging the loan by the introductory payment, when the reset payment is the figure that matters for affordability.
- Assuming a refinance will always be available in two years, when falling house prices or weaker credit can make it impossible.
- Ignoring the caps and the margin in the contract, which determine how high the rate can climb at each reset.
Questions
People also ask.
What does 2/28 mean?
The first two years carry a fixed rate and the remaining 28 years of the 30-year loan carry a rate that adjusts according to the loan terms.
Is a 2/28 ARM the same as a 5/1 ARM?
No, a 5/1 ARM is fixed for five years and then adjusts once a year, whereas a 2/28 is fixed for two years and then typically adjusts every six months.
Are 2/28 ARMs still available?
They are far less common since the financial crisis, and lenders now generally test affordability at the higher reset rate before approving a loan.
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