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Adjustable
Rate Mortgages (ARMs)
Adjustable
Rate Mortgages (ARMs)
These loans generally begin with an interest rate that
is 2-3 percent below a comparable fixed rate mortgage, and could
enable you to buy a larger home or a home in a more desirable
area.
The interest rate will change at a specified
interval (for example, every six months or every year). If
the interest rates go up due to changing market conditions,
your monthly mortgage payment will go up. Conversely, if
rates go down, your mortgage payment will go down.
There are literally hundreds of adjustable
rate mortgage programs to choose from. There are, however,
categories of adjustable rate mortgage programs:
- Amortizing ARMs
- Hybrid ARMs
- Hybrid Interest Only ARMs
- Option ARMs
Before analyzing each type of ARM program
category, it is important to understand the “mechanics” of
an ARM.
Common ARM Terms
- Index: The
index is the “moving” part of an ARM. The
index value will change over time, thereby causing the
interest rate on the loan to change. The index of
an ARM is the financial instrument that the loan is "tied" to. The
indices move up or down based on conditions in the financial
markets. For an explanation of each of the most common
indices and which may be best for you, contact your Freedom
Financial mortgage professional. The most common
indices are:
- Treasury Securities (these can be 6
month, 1 year, 3 year, etc.)
- LIBOR (London Interbank Offered Rate – i.e.,
the European Fed Funds Rate)
- Prime Interest Rate
- Cost of Deposits Index (CODI)
- Cost of Funds Index (COFI)
- Margin: The
margin is a number that is determined at the time of locking
in the interest rate or is determined by the loan program
selected. Unlike the index, the margin remains the
same over the entire life of the loan. Margins can
vary based on the loan type and/or the index used, but
generally range from 1.75% to 3.50%.
- Fully-Indexed Rate: This
is the “real” interest rate on the loan. Many
ARM programs have “teaser,” or artificially
low starting interest rates, to entice you to take the
product. Regardless of the starting interest rate,
one should always pay close attention to the fully-indexed
rate, as this is the real rate on the loan (excluding the
period of time the teaser-rate is effective). The
fully-indexed rate is the sum of the index and the margin.
- Caps: Caps
can either limit the amount the interest rate can change
or they can limit the amount the payment can increase:
- Interest Rate Caps:
- Periodic: These caps
limit the interest rate increase and may limit the interest
rate decrease for each adjustment period. For example,
if a loan is to adjust every six months, it may have
a 1% periodic rate cap, which limits the movement of
the rate to 1% every six months.
- Lifetime: This cap is
MANDATED BY FEDERAL LAW. Every ARM loan must have
an interest rate cap that limits the amount that the
interest rate can increase during the life of the loan. Federal
law does not limit the amount of the cap, it merely states
that such a cap must exist.
- Payment Cap: This cap
limits the amount a payment amount may increase. Payment
caps are usually set at one year intervals. The
most common payment cap is 7.50% per year. In other
words, if a minimum monthly payment is $1,000 during
the first year, the minimum payment during the second
year cannot exceed $1,075 ($1,000 x 107.50% = $1,075).
- Recasting: By
Federal law, all loans must be “recast” after ten years and every five years thereafter. When a loan is “recast,” the
payment the borrower must pay is determined by the current
principal balance, the current interest rate, and the
term of the loan remaining. On periodic interest
rate capped ARMs, the loan is automatically recast by
the natural terms of the loan. On payment capped
ARMs, the loan payment is adjusted at the time of the
recast without regard to the payment cap. In this
instance, the borrower’s payment is likely to increase
fairly significantly.
When a lender makes an adjustable rate mortgage,
the lender chooses the index which most closely approximates
the lender’s cost of acquiring money to lend out (i.e.,
the lender’s “cost of funds”). Lenders
cannot lend out money at their cost of funds, so the lender
adds a Margin to the index, since the Margin is the lender’s
profit, one can equate the Margin as a “profit margin.” The
higher the Margin the greater the lender’s profit. Of
course, the Margin also helps the lender compensate for greater
risks, such as low credit scores, non-owner occupant properties,
low or no income documentation, etc.
Caps (interest or payment) are placed on
the loan to protect both the borrower and the lender. The
borrower is protected by limits in payment increases. By
lowering payment increases, there is less likelihood of default,
which protects the lender.
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Amortizing ARMs
Standard ARM programs come in a variety of terms. Standard
ARMs are amortizing ARMs, meaning that the payments and the
rate adjust at the same intervals and will pay the loan off
over it’s initial term (i.e., 30 years) and will not
have negative amortization.
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Hybrid ARMs
There are mortgages that combine aspects of a fixed
and an adjustable rate mortgage combined in the same loan
- starting out fixed for a period of time (2-, 3-, 5-, 7-
or 10-years), then converts to an adjustable rate loan. When
the loan begins to adjust, typically the adjustment periods
are either each six months or each twelve months after the
initial fixed period. These loans have periodic interest
rate caps when the loan begins to adjust. When discussing
the caps on these loans, there are three caps discussed. The
first cap is the rate cap on the first adjustment (when the
loan goes from fixed to adjustable). The second cap
is the rate cap covering the ensuing adjustments (each six or
twelve months). The final cap is the lifetime interest rate
cap. For example, a 5/1 ARM might have 5/2/5 caps. This
indicates that after the initial fixed rate period of five
years, the loan will adjust every twelve months. After
the fixed period, the interest rate can go up no more than
5.00%; every twelve months thereafter, the rate increase
is limited to 2.00%; in no case can the interest rate ever
exceed 5.00% over the initial interest rate on the loan.
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Hybrid Interest Only ARMs
These loans are the same as the hybrid loans with
the exception that they have an initial period where the
minimum payments are interest-only payments. This keeps
the initial loan payments low and affordable. The interest-only
period usually runs with the fixed period, however, many
lenders are now extending the interest-only period beyond
the fixed period to ease a borrower into the transition from
fixed to ARM.
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Option ARMs
Option ARMs are the ultimate in “teaser” ARMs. An
Option ARM has two starting interest rates associated with
it. First is the rate which determines the starting minimum
payment. Second is the real interest rate, or the fully-indexed
rate. The interest rate on an Option ARM will adjust
on a monthly basis.
The borrower’s minimum starting payment
is based off of the interest rate which determines the minimum
starting payment. For example, the minimum starting
payment may be based on an enticing interest rate such as
1.00%.
The actual interest rate is the real fully indexed
rate, for example 5.50%. The borrower makes payments
at the lower payment rate of 1.00%, however, the loan accrues
interest at the fully-indexed rate of 5.50%, which may create
a deficit in the interest payment, thereby causing negative
amortization.
The reason the loan is called an “Option” ARM
is that the borrower will be given four payment options with
each monthly billing:
- Minimum payment – as defined and
calculated above.
- Interest-only payment – the payment
required to pay the fully-indexed rate of interest accruing
on the loan each month.
- 30-year payment – the payment required
to pay the loan off within the initial 30 (or 40) year
term of the loan (this payment will change each month as
this is a monthly adjustable rate loan.
- 15-year payment – the payment required
to pay the loan off within 15 years from the initial first
payment date.
Option ARMs may be based on a 40-year amortization.
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Home Equity Lines Of Credit (HELOCs)
A HELOC is a revolving line of credit and can be either
a first or a second mortgage. HELOCs are very useful
financial tools. They give you ready cash for large purchases,
allowing you to go into purchase negotiations with the power
of a cash transaction. For example, if you are looking
to purchase a car, you are not at the effect of the monthly
payment tactics of the car dealership. You can merely
negotiate the best price. In addition, the interest on
a HELOC may be tax deductible (check with your tax advisor
for details).
A HELOC is an adjustable rate loan, usually
tied to the Prime Lending Rate. Just like other ARMs,
the HELOC has an index and a margin. Typically there
are no payment or periodic rate caps, so the interest rate
charged on a HELOC is always the fully-indexed rate. The
typical lifetime interest rate cap on a HELOC is 18.00% (however,
they may vary).
Contact your Freedom Financial mortgage
professional today to discuss your specific loan situation.
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