for buying your home under an adjustable rate plan
Why
Homeowners Select this Type of Mortgage Loan
•
Lower
Interest Rate:
the
interest rate for ARMs can be significantly
lower than 30-year fixed
•
Temporary
Loan :
consumers
select the ARMs when they know they will be
in the home for 3 of fewer years
•
Loan
Qualifier :
homeowners
use the ARM when they need to qualify for larger
loan amounts
•
Assumable
Loans:
ARMs
are generally assumable when homeowners plan
to sell in the near future
•
Rates
can Decrease:
ARMs
rates can decrease in declining interest rate
markets
•
Convertible:
some
ARMs have a convertible feature to a fixed-rate
mortgage
Disadvantages
of this Type Loans
•
Additional
Costs:
the
interest rate can fluctuate which makes it hard
to plan your finances
•
Rising
Interest Rates:
in
rising interest rate markets, your monthly payment
can increase significantly
•
Negative
Amortization:
some
ARMs allow for negative amortization —
where caps prevent recovery of the full cost
of the loan
•
Expensive
Exit Costs:
convertible
features can be expensive and may charge a higher
interest rate than current prevailing rates
Introduction:
Adjustable Rate Mortgages
(ARM) became popular during the period of high
interest rates. It allowed many prospective
homeowners to finance their home purchase at substantially
lower rates.
Basically, ARM's adjust their
rates up or down during a given period.
This means that your monthly payment may go up
or down during your repayment term.
The big advantage of ARMs is that the
initial rate is lower than conventional fixed-rate
loans. The big disadvantage of course,
is that the initial rate can rise increasing your
total outlay for your mortgage.
ARMs are available in 30-year
and 15-year terms. Most ARMs are assumable
— which means you can transfer the ARM to
a new homebuyer with the same terms if the new
homebuyer qualifies for the mortgage loan.
Some ARMs have a convertible feature that allows
you to convert your ARM to a fixed-rate option
at designated times.
Lenders usually charge a nominal fee for convertibles.
Note
that in most cases the converted-to fixed rate
may be higher than the prevailing market rate.
ARM
Components:
The
ARM components include the following:
Index: the ARM begins with
a base number which
is tied to an published index that can go
up or down.
Two widely used ARM indexes
are the Treasury Rate Index and Cost of Funds
Index.
Margin: the margin
is the additional amount
that the lender adds to the index to
derive the Interest Rate that is charged for
the loan.
The margin covers the lender's cost and profit.
The margin may varies between 1.5 to 3.0 percentage
points.
Initial Interest Rate:the initial rate is the current
prevailing rate at the time that you
lock-in your position, which is generally
one to three percentage points lower than
the prevailing 30-year fixed loan rate.
New Interest rate:
the adjusted interest rate over the life of
the loan.
New interest rate is calculated at the time
of adjustment
New Interest Rate
= index + margin
Adjustment Interval:
the time between the interest rate is scheduled
to change. The ARM can change every six months,
annually, every three years, or every five
years.
an ARM with an adjustment interval
of six months is called a 6-month
ARM.
an ARM with an adjustment interval
of 1 year is called an 1-Year
ARM.
and so forth
At the time of adjustment, your lender will
recalculate your loan payment under the new
interest rate and remaining term on the loan.
For example: let's
say that you close on 1-year ARM at 5.5% for
30 years. Your monthly payment during the
first year (full 12 months) will be as follows:
Borrows Amount:
$100,000
Interest Rate
5.5%
Payment Term
30 Years (360 months)
Monthly Payments Yr-1
$567.79
At the end of one year, your
ARM will adjust and reflect the new interest
rate. Your lender will then recalculate
your new monthly payment using a 29-year term:
Borrowed Amount:
$100,000.00
(less) principal
paid Yr-1
$1347.09
New Borrowed Amount
$98,652.91
New Interest Rate
6.0%
Payment Term
29 Years (548 months)
Monthly Payments Yr-2
$598.83
Interest Rate Caps:
interest rate caps protect the consumer in
the event that interest rates rise too rapidly.
There are lifetime caps
and adjustment rate caps. Make sure
your understand these caps when finalizing
your loan decision.
Example
Life-Time Cap:
ARM index rate: 4.5%
ARM margin: 2.5%
Life-Time Cap: 4%
Interest rate: 7.0%
The ARM index has jumped to 8%
The new interest rate equals 8%
+ 2.5% = 10.5%
The life-time cap limits the new
interest rate to: 4.5% + 4% = 8.5%
Example Adjustment Rate
Cap:
ARM index rate: 4.5%
ARM margin: 2.5%
Periodic Adjustment Rate Cap: 1%
Interest rate: 7.0%
The ARM index has jumped to 6%
The new interest rate equals 6%
+ 2.5% = 8.5%
The adjustment rate cap limits the
new interest rate for the adjustment
period to: 4.5% + 1% = 5.5%
Payment Caps:
limits the payment amount the consumer needs
to pay at time of interest rate adjustments.
Note: payment caps may
not provide enough payment to cover
the required interest charges during rising
interest rates. Under this condition, the
consumer will experience negative amortization
— where the interest amount not covered
is added to the principal of the mortgage
loan.
Example: if your
payment cap limits your monthly payment to
$1050 when the true payment should be $1250
due to ARM rate adjustments, the unpaid $200
will be added to the principal mortgage loan
balance for later payment.
Let
us find a lender near you with the best rate
and terms.
*The
recommended product, term and use are listed as
illustrative purposes on how you might use the equity
in your home. Please note that your circumstances
may be different and that the recommended product,
term and use may not fit your particular need.
Two widely used ARM indexes
are the Treasury Rate Index and Cost of Funds Index.
Lenders on the East Coast
and Mid-West typically use the Treasury Rate Index,
which indices are the weekly or monthly average
yields on U.S. Treasury securities.
These indexes reflect the state of the economy
and are more volatile as they move with the market.
The index rate (which determines the mortgage rate
that you pay) fluctuates daily
based on market conditions and economic indicators.
Nobody can predict how rates will move, but you
can get a good idea of what might
change rates by understanding elements that drive
economic conditions. These may include:
An assumability clause allows the seller
of the home to transfer the mortgage loan to the homebuyer.
This could be an attractive feature in the
sale of a home during high interest markets.
For example, if your ARM is capped at 1-2 points lower
than prevailing ARM rates, your mortgage loan has
value.
To illustrate this, let's say that interest rates
rise and the prevailing ARM rate is 11%. Your existing
ARM rate has risen respectively but has a maximum
rate of 9%. You can transfer the 9% capped ARM to
the new homebuyer.
This assumability feature can
become a selling point in the sale of your home.
Note on the other hand, that interest rate markets
have been relatively low since the late-1980s. The
new homebuyer can generally find an ARM that is as
low or lower than your current ARM. So
in low interest rate markets, the assumability clause
may not have value.
The convertibility clause allows the borrower
to convert their existing ARM over to an prevailing
fixed-rate loan. This may become an exercised
feature when interest rates begin to rise rapidly.
The convertibility feature does
have its cost, however. First, your conversion
rate on a fixed-rate loan is generally higher than
your current ARM rate. Second, lenders may tack on
the conversion rate an additional margin as compensation
for the convertibility feature. Make
sure your read the fine print.
Teaser Rates: some lenders
will entice borrowers with a teaser rate. Note that
at the end of the teaser rate, lenders typically adjust
the rate to the maximum amount. Make sure you calculate
your monthly payment at the potential maximum rate.
Payment Recalculations:
at each adjustment period, lenders must recalculate
your monthly payment at the new rate, remaining term,
and existing mortgage balance after all existing payments
and pre-payments made on the mortgage loan.
Lenders do make mistakes and overcharge ARM borrowers.
You should double check the
banks calculation to make sure you are not
overpaying or underpaying your ARM mortgage. This
requires you to calculate your new payment with the
new rate (based on prevailing index and lender margin),
remaining term and mortgage balance.
Download our amortization worksheet to help you in
that calculation: click
here.
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