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ADJUSTABLE RATE MORTGAGES (ARMs) - FACTS
CHANGING INTEREST RATES
Unlike Fixed Rate Mortgages, Adjustable Rate Mortgages (ARMs), are mortgages where the interest rate changes periodically, usually in relation to one of several financial industry indexes. Payments may go up or down accordingly.
LOWER RATES CAN HELP YOU QUALIFY FOR LARGER LOANS
Lenders generally charge lower initial rates for ARMs than for fixed-rate mortgages. This makes the ARM easier on your pocketbook at first than a fixe-rate mortgage for the same amount. It also means that you might qualify for a larger loan because lenders sometims make this decision on the basis of your current income and the first year's payments.
POTENTIAL TO COST YOU LESS IN THE LONG-RUN
an ARM could be less expensive over the long period than a fixed-rate mortgage - for example, if interest rates remain steady over an extended period of time or move lower.
POTENTIAL RISK
The risk with an ARM is that rates may rise over time, thus resulting in higher monthly payments required. It's a trade-off - you get a lower rate with an ARM in exchange for assuming more risk.
REDUCING RISK
Many ARMs have "caps" that protect borrowers from extreme increases in interest rates or monthly payments. Others allow borrowres to convert an ARM to a fixed-rate mortgage. While these may offer real benefits, they may also cost more, or add special features, such as a negative amortization.
FEATURES OF AN ARM
ADJUSTABLE PERIOD
With most ARMs, the interest rate and monthly payment change either every year, every three years, or every five years. However, some ARMs have more frequent interest and payment changes. The period between one rate change and the next is called the adjustment period. A loan with an adjustment period of one year is called a one-year ARM, and the interest rate can change once every year.
THE INDEX
Most lenders tie ARM interest rate change to changes in an "index rate". These indexes usually go up and down with the general movement of interest rates. If the index rate moves up, so does your mortgage rate in most circumstances, and you will probably have to make higher monthly payments. On the other hand, if the index rate goes down, your monthly payment may go down.
Lenders base ARMs on a variety of indexes. Among the most common are:
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T-BILL
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The rates on one, three or five year Treasury securities, national or regional
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MTA
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Twelve month Treasury Index
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LIBOR
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London InterBank Offering Rate
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COSI
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Cost Of Savings Index (cost to banks for passbook savings, CDs, Money Markets, etc.)
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CODI
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Cost Of Deposits Index (typically 30 day CD's)
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COFI
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Cost Of Funds Index - (Mutual funds)
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CMT
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Constant Maturity Treasury
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(NOTE- Every lender uses only those indexes of that lender's choosing, some of which can be refined to be determined based upon national, regional or strictly local indexes - such as in COSI, CODI or COFI)
Because there are so many indexes to base rates upon, it is important that you ask your Mortgage Expert which index a particular mortgage is based upon, how often it changes, how it has behaved in the past, and where it is published.
THE MARGIN
To determine the interest rate on an ARM, lenders add a few percentage points to the index rate. this is called the "margin". The amount of the margin can differ from one lender to another, but is usually constant over the life of the loan.
INDEX RATE + MARGIN = ARM INTEREST RATE
For example, if Lender A and Lender B use the same Index, you may still see two different rates for an otherwise similar loan because of the margin. If the index is 5%, and Lender A sets a margin of 2%, and Lender B sets a margin of 3%, then the actual Interest rate for Lender A would be 7% (5% index plus 2% margin), while the Interest rate for Lender B would be 8% (5% index plus 3% margin).
In comparing ARMs, look at both the index and the margin for each plan. Some indexes have higher average values, but they are usually used with lower margins. Be sure to discuss these issues and numbers with your Mortgage Expert.
CONSUMER CAUTION
DISCOUNTS
Some lenders offer initial ARM rates that are lower than the sum of the index and the margin. Such rates, called "discounted rates", are often combined with large initial loan fees (points), and with much higher interest rates after the discount expires.
Very large discounts are often arranged by the seller. The seller pays an amount to the lender so the lender can give you a lower rate and lower payments early in the mortgage term.
This arrangement is referred to as a "seller buydown". The seller may increase the sales price of the home to cover the cost of the buydown.
A lender may use a low initial rate to decide whether to approve your loan, based on your ability to afford it.
IF you are going to remain in your home for an extended number of years, you should be careful to consider whether you will be able to afford payments in later years when the discount expires and the rate is adjusted. If, however, you are sure you will be selling the property before the monthly payments rise too high, this type of arrangement may benefit you more. Regardless of your future home plans, be sure to discuss these factors with your Mortgage expert. The more your Mortgage Expert knows about your unique financial situation and needs, the more likely you will receive the loan that is right for you.
INTEREST RATE CAPS
An interest-rate cap places a limit on the amount your interest rate can increase. A cap is like insurance, so ARMs with caps may cost more than ARMs without them. Interest caps come in two versions:
PERIODIC CAPS
Limit the interest rate increase from one adjustment period to the next.
OVERALL CAPS
Limit the interest rate increase over the life of the loan.
An ARM may have both a periodic and an overall interest rate cap.
EXAMPLE ARM WITH AND WITHOUT A CAP
For example, a mortgage has an initial rate of 10%. After the first year, if the actual interest rate rises by 3%, then the second year's payments would be calculated at 13% unless the PERIODIC RATE CAP is LESS. In that case, the second year's payments can only go up by the CAP amount. For the example below, we set a CAP of 2%.
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YEAR
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ARM INTEREST RATE
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MONTHLY PAYMENT
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FIRST YEAR
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10%
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$570.42
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SECOND YEAR
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+3%
13%
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$717.12
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SECOND YEAR WITH 2% CAP
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+2%
12%
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$667.30
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In the above scenario, because a 2% CAP is in effect, monthly payments in the 2nd year are $49.82 less per month than if there had been no CAP in place.
CAVEAT
A drop in interest rates does not always lead to a drop in monthly payments. In fact, with some ARMs that have interest rate caps, your payment amount may increase even though the index rate has stayed the same or declined. This may happen after an interest rate cap has been holding your interest rate down below the sum of the index plus margin.
OVERALL RATE CAPS
In general, the rate on your loan can go up at any scheduled adjustment when the index plus the margin is higher than the rate you are paying before that adjustment. An ARM might also have an OVERALL RATE CAP.
For example, if your initial interest rate is 7% (5% index and 2% margin), and if the index goes up 1% in each of the first ten years, without an overall rate cap, you would potentially have reached an interest rate of 19% by the tenth year. WIth a 5% overall rate cap, your interest rate would never go over 12%.
PAYMENT CAPS
Some ARMs include Payment Caps, which limit your monthly payment increase at the time of each adjustment, usually to a percentage of the previous payment. In other words, with a 7.5% payment cap, a payment of $100 could increase no more than $7.50 (to a total of $107.50) in the first adjustment period, and to a total of no more than $115.56 in the second. So even if the interest rate rises, with a payment cap, that increase would be no more than the payment cap allows for that adjustment.
NEGATIVE AMORTIZATION
Be sure to find out about "negative amortization" if your ARM contains a payment cap. Negative amortization means the mortgage balance is increasing. this occurs whenever your monthly mortgage payments are not large enough to pay all of the interest due on your mortgage.
Because payment caps limit only the amount of payment increases, and not interest-rate increases, payments sometimes do not cover all of the interest due on your loan. this means that the interest shortage in your payment is automatically added to your debt, and interest may be charged on that amount. You might therefore owe the lender more later in the loan term than you did at the start. However, an increase in the value of your home may make up for the increase in what you owe, through "appreciation".
Your Mortgage Expert can help explain the advantages and disadvantages of Negative Amortization (Neg-Am) loans.
PREPAYMENT AND CONVERSION
If you get an ARM and your financial circumstances change, you may decide that you don't want to risk any further changes in the interest rate and payment amount. When you are considering an ARM, ask for information about prepayment and conversion.
PREPAYMENT PENALTIES
Some agreements may require you to pay a special fee or penalty if you pay off the ARM early. Many ARMs allow you to pay off the loan in full or in part without penalty whenever the rate is adjusted. Prepayment details are sometimes negotiable. If so, you may want to negotiate for no penalty, or for as low a penalty as possible.
CONVERSION
Your agreement with the lender can have a clause that lets you convert the ARM to a fixed-rate mortgage at designated times. When you convert, the new rate is generally set at the current market rate for fixed-rate mortgages (based on your unique financial and credit situation).
The interest rate or up-front fees may be somewhat higher for a convertible ARM. Also, a convertible ARM may require a special fee at the time of conversion.
POINTS
A point is equal to one percent of the principle amount of your mortgage. For example, if you get a mortgage for $500,000, one point means you pay $5,000 to the lender. Lenders frequently charge points in both fixed-rate and adjustable rate mortgages in order to increase the yield on the mortgage, and to cover loan closing costs, as well as to compensate for potential risk factors such as a lower than optimal credit score (FICO), or other factors.
These points are usually collected at closing and may be paid by the borrower or the seller, or may be split between them.
Information on ARM's provided by U.S. Department of Housing and Urban Development www.hud.gov
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