SOFR ARMs Are Here: What the New Index Means for Your Mortgage

SOFR is replacing Libor as an ARM index. Margins and rate caps will change, too.
Holden Lewis
By Holden Lewis 

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Adjustable-rate mortgages are going through a transition that introduces a new index, new rules and new terminology. As a result, an ARM you get today is likely to differ from ARMs of the past. And if you have an ARM now, changes are coming to your loan.

This article explains why and how ARMs are changing, and when. But first, a reminder of what makes ARMs tick.

How ARMs work

An adjustable-rate mortgage has an interest rate that can change at predetermined intervals. These periodic rate changes are governed by a web of rules. Central to these is the structure of an ARM itself.

An ARM has two parts: the margin and the index. The margin is a specified number of percentage points that never changes, while the index is an interest rate that moves up or down from time to time. The index plus the margin is the interest rate you pay.

This mental image may help: Picture an ARM as a book (the margin) perched atop an air mattress (the index). The book's thickness never changes. Periodically, air is pumped into the air mattress, inflating it higher, or is released from the air mattress, deflating it lower. Your interest rate is the height of the top of the book after the air mattress has been inflated or deflated.

Now lenders are swapping out air mattresses. That's what this transition is about. The changeover affects many ARMs originated after Sept. 30, 2020, and could eventually affect about $1 trillion in older ARMs.

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Why ARM indexes are changing

For years, most adjustable-rate mortgages have used a benchmark interest rate called Libor as the index (the mattress in the analogy above). But corrupt bankers were caught manipulating Libor, which remains vulnerable to chicanery, so regulators are getting rid of it. Libor, which stands for London Interbank Offered Rate, is due to be phased out by the end of 2021 in a colossal worldwide undertaking.

SOFR is the new air mattress: For ARMs, Libor is being replaced by the Secured Overnight Financing Rate, or SOFR, which is based on real-life financial transactions and is resistant to covert manipulation. SOFR is based on the cost of borrowing money overnight when the borrower puts up U.S. government debt as collateral.

When the change is happening: The transition to SOFR loans has already begun. Fannie Mae and Freddie Mac won't buy Libor ARMs with application dates after Sept. 30, 2020. Most lenders stopped offering conventional Libor loans around that time. For example, PNC Bank says it started offering SOFR ARMs beginning Aug. 15, 2020, and Flagstar Bank says it started offering them Oct. 1, 2020.

The Federal Housing Administration, Department of Veterans Affairs and Department of Agriculture were scheduled to stop insuring or guaranteeing new Libor ARMs at the end of 2020.

As of early November 2020, Libor ARMs were still available for jumbo mortgages, but jumbos will have to move away from Libor by the end of 2021.

How SOFR ARMs differ from Libor loans

SOFR-based loans differ from their Libor cousins when it comes to margins, rate adjustment periods and interest rate caps.

Margins are bigger on SOFR loans

Regulators recommend that lenders base ARMs on the 30-day average SOFR. Until recently, most new ARMs were indexed to the 1-year Libor. But switching from 1-year Libor to 30-day SOFR isn't an apples-to-apples replacement, because the SOFR rates are lower.

When SOFR ARMs reset, the rate will be adjusted every six months.

From September 2014 to early 2020, the difference averaged about 0.73 percentage points, according to the Urban Institute. The difference has narrowed since the beginning of the COVID-19 pandemic. In early November 2020, the 30-day SOFR was about 0.22 percentage points lower than 1-year Libor.

To compensate, margins on SOFR ARMs are bigger — 2.75% to 3%, compared with Libor's typical margin of 2.25%.

To return to our imagery, if the indexes were air mattresses, SOFR would be thinner than Libor. And of the books representing the margins, the SOFR tome would be thicker than the volume atop Libor.

SOFR loans adjust more frequently

When Libor-based ARMs eventually hit reset, the rate is adjusted once a year. By contrast, when SOFR ARMs reset, they will be adjusted every six months.

The reason is that the 1-year Libor looks forward, while SOFR looks backward. Libor reflects where interest rates are expected to go in the next 12 months, while SOFR reflects an average of short-term rates during a recent 30-day period. From investors' viewpoint, SOFR rates go out of date more quickly, so they'll be refreshed more frequently.

SOFR interest rate caps are smaller

ARMs have rate caps, which limit how much the interest rate can change with each adjustment. Libor ARMs can go up or down a maximum of two percentage points with each annual adjustment. SOFR ARMs will be limited to going up or down a maximum of one percentage point when they are adjusted every six months.

SOFRs are named differently

Most ARMs start with an introductory interest rate that lasts for several years before the first adjustment, or reset. A Libor ARM with a three-year introductory rate is called a 3/1 ARM because the initial rate lasts three years, then the rate is adjusted every one year afterward. The number before the slash is the length of the introductory rate, and the number after the slash denotes how many years pass between rate adjustments.

Because SOFR ARMs will be adjusted at six-month intervals, the number after the slash denotes how many months, not years, pass between rate adjustments. When a SOFR ARM has an initial rate lasting three years, followed by rate adjustments every six months, it’s called a 3/6 ARM. If the initial rate lasts five years, it's a 5/6 ARM. There are also 7/6 and 10/6 ARMs.

Lenders know there's a learning curve. "We explain and educate borrowers on the new terminology and adjustment periods in our new ARM disclosures, which are provided on all SOFR ARM applications," says Mark Daly, Flagstar Bank's senior vice president for mortgage originations support.

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Shopping for a SOFR ARM

An adjustable-rate mortgage might make sense if you intend to own the home for just a few years or plan to pay off the loan quickly. If you decide that an ARM is right for you, shopping for a SOFR-indexed loan isn't much different from getting a Libor-based mortgage.

"The structure and terms for either a Libor- or SOFR-based ARM loan are very similar, aside obviously from the different indexes," PNC Bank mortgage executive Peter McCarthy said in an email.

The main difference is the naming convention. Don't make the mistake of thinking "5/6" means a six-year gap between rate adjustments!

What will happen to existing Libor loans?

All ARM contracts have language that allows lenders to find a replacement if the loan's index goes away. Eventually, existing Libor-indexed ARMs will be switched over to SOFR. The timing has yet to be worked out, depending partly on when British regulators call it quits on Libor.

On this side of the Atlantic, regulators have stressed the need for an "effective transition." The lender must provide notice 60 to 120 days before the first payment under the adjusted rate.

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