Significance

• Jumbo ARMs are significant for two reasons. First, they facilitate much larger mortgages. In high-price real estate markets like New York City and California, among others, normal mortgages would not be able to cover the borrowing levels that these markets reached as home prices escalated in the 1990s and in this decade. Second, the ARM feature allows many potential homeowners to buy homes with interest payment cash flows below market rates in the initial years of the contract. Both of these factors probably boosted homeownership in recent years and may have contributed to escalating home prices. When the interest rates on mortgages are low, then home values tend to be higher.
  
  

Function

• Conventional jumbo ARMs function like normal mortgages, in that principal and interest payments service the debt and as the principal balance is lowered by each month's payment, equity in the home goes up. At the beginning of the loan, the mortgage's interest rate is generally lower than the prevailing market rate. Then, there is an adjustment period during which the rate can be changed based on movements in a specified market rate index such as the London Interbank Offered Rate (LIBOR) or the Constant Maturity Treasury (CMT) market. There can be specific caps and floors in place that limit how high rates can be moved up, or down, as well. Margins are also a factor to consider as they will specify the margin above the index market rate that the mortgage's interest rate can be set to.
  
  

Types

• There are as many types of jumbo ARMs as the market can devise, but they generally have an initial period of 3, 5 or 7 years during which the interest rate is lower than comparable market rates. Then, during the adjustment period, the rate can float along with the index it is tied to. This would continue for the remainder of the 30-year period. Other types of ARMs will specify how often the rate can be changed after the initial period and by how much it can change. The more frequent the change the more likely that the rate will go up quickly in a rising interest rate environment. Hybrid ARMs function like a standard fixed-rate mortgage for a specified period, and then become adjustable rate later on.
  
  

Considerations

• The most important consideration is to fully understand how and when the interest rate can be increased. It is important to understand how the floating rate is determined, which index it is linked to and how that index is moving in the marketplace. If the interest rate can be adjusted to levels at which the homeowner cannot pay it, then there will be a foreclosure. Users of jumbo ARMs need to be aware of how high rates can go and to be able to forecast their ability to pay these rates in the future. A lot can happen in a 30-year period.
  
  

Benefits

• For homeowners who can properly forecast their exposure to rising rates, and who have the ability to increase their own earnings in the future or as their careers progress, the jumbo ARM has the benefit of allowing them to acquire a more valuable piece of real estate than a conventional fixed mortgage might allow.