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Adjustable-rate Mortgage
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FIND
OUT HOW AN ARM WORKS
Possibly
one of the most popular, yet misunderstood forms of alternate financing
is the adjustable-rate mortgage. Usually referred to as an
ARM, its popularity with borrowers is due to a lower interest rate
than a fixed-rate loan. It is popular
with the lenders because the ARM shifts the risk of interest rate
fluctuations to the borrower.
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Although
borrowers would rather have the security of a fixed-rate loan provided
the rate is not too high, the ARM has maintained its popularity in the
market despite competitively priced mortgage loan rates.
An
ARM is a loan that allows the lender to adjust the interest rate so it
reflects fluctuations in the cost of money more accurately. However,
with an ARM, the borrower is the one who is affected by interest rate
movements, not the lender. If interest rates rise, the borrowers
payments also go up - if the rates fall, the borrowers monthly payments
will drop along with the declining rates.
HOW
AN ARM WORKS
The
borrower's interest rate is determined by the cost of money at the time
the loan is made. Then the rate is tied to a recognized index your
lender is currently using for this loan. Your future interest adjustments
are then based on the upward or downward movements of this index.
An index is a reliable statistical report that reflects the approximate
change in the cost of money. Some examples of this would
be the monthly average yield on three year treasury securities, or the
national average mortgage contract rate for purchases on previously occupied
homes. The rise and fall of your payments will fluctuate with the
index preferred by the lender for this loan program when your loan was
made.
To
insure that the expenses of administration and profit are included in
the payments to the lender, it is necessary for the lender to add a margin
to the index. Different lenders use different margins which explains
the variation in interest rates offered for the same loan program.
Margins range from 2% to 4% and are added to the index to come up with
the interest rate you pay (margin + index = interest rate). It's
the fluctuation of the index rate that causes the borrowers interest rate
to increase or decrease.
ELEMENTS
OF AN ARM
- Index
- margin
- "Teaser
rates"
- Rate
adjustment period
- Interest
rate cap
- Mortgage
payment adjustment period
- Mortgage
payment cap (if any)
- Negative
amortization cap (if any)
- Conversion
option (if any)
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Lenders generally
use an index that will be responsive to fluctuations in our economy
- usually a one-year Treasury security or the cost-of-funds index (COFI).
The cost-of-funds index is more stable than the Treasury index because
it doesn't rise or fall as sharply over the long term as the Treasury
index.
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MARGIN:
The margin is the
difference between the index rate and the interest charged to the borrower.
The margin doesn't change throughout the loan term.
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"TEASER
RATES"
A "teaser rate"
is a reduced, first-year introductory interest rate designed to attract
borrowers to ARM's. In the past, lenders were losing money on
fixed-rate mortgages because these loans were yielding less than the
prevailing cost of money. Offering the adjustable-rate mortgage
allowed lenders to insulate themselves from these losses and increase
earnings by passing the risk of interest rate fluctuations on to the
borrower. To make the ARM attractive to borrowers, a low beginning
interest rate was offered and through time these introductory rates
became known as "teaser rates". The interest rate would then rise
at each rate adjustment period until the rate equaled the index rate
+ the margin. For example, let's say that the introductory rate
("teaser rate") for your adjustable-rate loan started at 4.5% interest
and would adjust upward 1.0% every six months. If your index for
this loan was 5.0% and the lenders margin was 3.0%, then the interest
on your loan for the first six months would be 4.5%. Six months
later, it would increase to 5.5% and so on until the fully-indexed rate
was reached. To find the fully-indexed rate, you would add the
index to the margin (5.0% + 3.0%). After the fully-indexed rate
was reached, your loan would then fluctuate with the index on your loan.
If the index goes up or down, your payment would increase or decrease
with the rise or fall of the index on your adjustment period change
date.
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RATE
ADJUSTMENT PERIOD:
The borrowers interest
rates on an adjustable-rate mortgage are allowed to be adjusted at certain
intervals during the loan term. Depending on the type of adjustable
loan you have, this interval could be six months, one year, three years
or more.
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INTEREST
RATE CAP:
There are limits
on just how much your payments can go up if you have an ARM. Usually
these caps are in the form of interest rate caps and/or payment caps.
An interest rate cap determines the maximum number of percentage points
your interest can increase over the life of the loan.
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MORTGAGE
PAYMENT ADJUSTMENT PERIOD:
The mortgage
payment adjustment period is the agreed upon intervals at which the
payments of principal and interest are changed. The lender
can either adjust the rate periodically and adjust the mortgage payment
to reflect the change, or the lender can adjust the rate more frequently
than the mortgage payment is adjusted. For example, the loan agreement
may call for the interest to be adjusted every six months, but the payment
to be adjusted every three years. This scenario could be a problem.
If in the interim between payment periods (3 years), interest rates
have gone up or down too much, there will have been too much or too
little interest paid on the loan by the borrower over that period of
time, and the difference will be added to or subtracted from the loan
balance. When unpaid interest is added to the loan balance, it
is called negative amortization.
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MORTGAGE
PAYMENT CAP:
A mortgage payment
cap is the maximum allowable interest rate the lender can charge on
your loan regardless of what happens in the market. Depending
on your particular loan program, this is a percentage (usually 5% to
7.5% annually) that can be added to your fully indexed rate if the market
warrants moving that high. For example, if your fully indexed
rate is 8% and your annual cap is 6%, your loans life cap would be 14%.
Mortgage payment
caps were designed to limit unrestricted increases by lenders and keep
the borrowers payments at a manageable level. Some lenders impose
payment caps, some impose interest rate caps and some lenders use both.
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NEGATIVE
AMORTIZATION CAP:
A negative amortization
cap limits the amount of negative amortization that can be reached on
a loan. When the cap is reached, the loan is re-amortized to a
level sufficient to pay off the loan over the remaining term of the
loan.
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CONVERSION
OPTION:
A conversion option
on an adjustable rate mortgage is called a Convertible ARM. A
conversion option gives the borrower the option to convert their adjustable-rate
mortgage to a fixed-rate loan. Convertible Arm's normally have
a higher initial interest rate (even the converted fixed rate will usually
be higher). You will usually have a time frame in which to convert
the loan to a fixed rate. For example, you might have to make
your decision to convert the loan sometime after the first year and
before the fifth year ends. In most cases, there is also a conversion
fee imposed on the borrower (for instance 1% of the total loan amount).
There are many
different ARM programs to choose from with many available options.
If you are considering an adjustable-rate mortgage, we will be happy to
explain your options to you and make sure you have the right program to
meet your needs.
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