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What is an Adjustable Rate Mortgage or ARM?
With your traditional fixed-rate mortgage, the interest rate
stays the same during the life of the loan. But that is not
the case with an ARM, the interest rate changes periodically
and may go up or down accordingly. It is more of a riskier
loan than a typical Mortgage Loan. Lenders generally charge
lower initial interest rates for ARMs than for a fixed-rate
mortgage for the same amount. It also means that you might
qualify for a larger loan because lenders sometimes make this
decision on the basis of your current income and the first
year's payments. Moreover, your ARM could be less expensive
over a long period than a fixed-rate mortgage--for example,
if interest rates remain steady or move lower. You have to
weigh the risk that an increase in interest rates could lead
to higher monthly payments in the future against the disadvantages.
It's a trade-off where you get a lower rate with an ARM in
exchange for assuming more risk.
Here are some questions you need to answer when considering
this type of loan:
- Is my income likely to rise enough to cover higher mortgage
payments if interest rates go up?
- Will I be taking on other sizable bills (tuition), in
the near future?
- How long do I plan to own this home? (If you plan to
sell soon, rising interest rates may not pose the problem
they do if you plan to own the house for a long time.)
- Can my payments increase even if interest rates generally
do not increase?
Here are some answers to questions regarding ARM
Loans:
Some newspaper ads for home loans show surprisingly low rates.
Could these be loans for Adjustable Rate Mortgages? Some
of the ads you see are for adjustable
rate mortgages (ARMs). These loans may have low rates
for a short time -- maybe only for the first year. After that,
the rates can be adjusted on a regular basis. This means that
the interest rate and the amount of the monthly payment can
go up or down.
Will I know in advance how much my payment may go up? With
an adjustable-rate mortgage, your future monthly payment is
uncertain and sometimes risky. Some types of ARMs put a ceiling
on your payment increase or rate increase from one period
to the next. Virtually all must put a ceiling on interest-rate
increases over the life of the loan.
Is an ARM the right type of loan for my situation? That
depends on your financial situation and the terms of the ARM.
ARMs carry risks in periods of rising interest rates, but
can be cheaper over a longer term if interest rates decline.
You will be able to answer these questions better once you
understand more about adjustable-rate mortgages. This information
should help.
Mortgages have changed, and so have the questions that need
to be asked and answered. Shopping for a mortgage today is
not the most simple process it is sometimes complex. In the
past, Most home mortgage loans had interest rates that did
not change over the life of the loan. Choosing among these
fixed-rate mortgage loans meant comparing interest rates,
monthly payments, fees, prepayment penalties, and due-on-sale
clauses.
Today, many loans have interest rates and monthly payments
that can change from time to time. To compare one ARM with
another or with a fixed-rate mortgage, you need to know about
indexes, margins, discounts, caps, negative amortization,
and convertibility. You need to consider the maximum amount
your monthly payment could increase. Most important, you need
to compare what might happen to your mortgage costs with your
future ability to pay.
The Basics of ARM's
The Adjustment Period
With most ARMs, the interest rate and monthly payment change
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. So, 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 changes 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 ARM rates on a variety of indexes. Among the
most common are the rates on one-, three-, or five-year Treasury
securities. Another common index is the national or regional
average cost of funds to banks. A few lenders use their own
cost of funds, over which--unlike other indexes--they have
some control. You should ask what index will be used and how
often it changes. Also ask how it has behaved in the past
and where it is published.
The Margin
To determine the interest rate on an ARM, lenders add to the
index rate a few percentage points called the "margin."
The amount of the margin can differ from one lender to another,
but it is usually constant over the life of the loan.
__________________________________________________________________________
Index rate + margin = ARM Interest Rate
__________________________________________________________________________
Let's say, for example, that you are comparing ARMs offered
by two different lenders. Both ARMs are for 30 years and an
amount of $65,000. (All the examples used in this document
are based on this amount for a 30-year term. Note that the
payment amounts shown here do not include items like taxes
or insurance.)
Both lenders use the one-year Treasury index. But the first
lender uses a 2% margin, and the second lender uses a 3% margin.
Here is how that difference in margin would affect your initial
monthly payment.
Home sale price: $85,000
Less down payment: -20,000
Mortgage amount: $65,000
Mortgage term: 30 years
First Lender: One Year Index = 8%, Margin = 2%, ARM interest rate =10%, Monthly Payment @ 10% = $570.42
Second Lender: One-year index =8%, Margin =3%, ARM interest rate = 11%, Monthly payment @11% = $619.01
In comparing ARMs, look at both the index and margin for
each plan. Some indexes have higher average values, but they
are usually used with lower margins. Be sure to discuss the
margin with your lender.
Consumer Beware:
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 sale 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. 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.
Here is how a discount might work. Let's assume the one-year
ARM rate (index rate plus margin) is at 10%. But your lender
is offering a 8% rate, your first monthly payment would be
$476.95.
But don't forget that with a discounted ARM, your low initial
payment will probably not remain low for long, and that any
savings during the discounted period may be made up during
the life of the mortgage or be included in the price of the
house. In fact, if you buy a home using this kind of loan,
you run the risk of...
Payment Shock
Payment shock may occur if your mortgage payment rises very
sharply at the first adjustment. Let's see what happens in
the second year with your discounted 8% ARM.
ARM Interest Rate Monthly Payment
First year (w/discount) 8% $476.95
2nd year @ 10% $568.82
As the example shows, even if the index rate stays the same,
your monthly payment would go up from $476.95 to $568.82 in
the second year.
Suppose that the index rate increases 2% in one year and
the ARM rate rises to a level of 12%.
ARM Interest Rate Monthly Payment
First year (w/discount) 8% $476.95
2nd year @12% $665.43
That's an increase of almost $200 in your monthly payment.
You can see what might happen if you choose an ARM impulsively
because of a low initial rate. You can protect yourself from
increases this big by looking for a mortgage with features,
described next, which may reduce this risk.
Ways to reduce your risk:
Besides an overall rate ceiling, most ARMs also have "caps"
that protect borrowers from extreme increases in monthly payments.
Others allow borrowers 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 negative amortization.
Interest-Rate Caps
An interest-rate cap places a limit on the amount your interest
rate can increase. Interest caps come in two versions:
1. Periodic caps- which limit the interest-rate increase
from one adjustment period to the next; and Overall caps,
which limit the interest-rate increase over the life of the
loan. By law, virtually all ARMs must have an overall cap.
Many have a periodic interest rate cap. Let's suppose you
have an ARM with a periodic interest rate cap of 2%. At the
first adjustment, the index rate goes up 3%. The example shows
what happens.
ARM Interest Rate Monthly Payment
First year @ 10% $570.42
2nd year @13% (without cap) $717.12
2nd year @12% (with cap) $667.30
Difference in 2nd year between payment with cap payment without
= $49.82.
A big 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.
Banklady TIP: With some ARMs payments may increase
even if the index rate stays the same or declines.
Look below at the example where there was a periodic cap
of 2% on the ARM, and the index went up 3% at the first adjustment.
If the index stays the same in the third year, your rate would
go up to 13%.
ARM Interest Rate Monthly Payment
First year @ 10% $570.42
If index rises 3%...
2nd year @12% (with 2% rate cap) $667.30
If the index stays the same for the 3rd year @13% $716.56
Even though index stays the same in 3rd year, payment goes
up $49.26
A general rule is the rate on your loan can go up at any
scheduled adjustment date when the index plus the margin is
higher than the rate you are paying before that adjustment.
The example below shows how a 5% overall rate cap would affect
your loan.
ARM Interest Rate Monthly Payment
First year @10 % $570.42
10th year @19% (without cap) $1,008.64
10th year @ 15% (with cap) $813.00
Let's say that the index rate increases 1% in each of the
first ten years. With a 5% overall cap, your payment would
never exceed $813.00 - compared to the $1,008.64 that it would
have reached in the tenth year based on a 19% indexed rate.
2. 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 1/2% payment cap, a payment of $100 could
increase to no more than $107.50 in the first adjustment period,
and to no more than $155.56 in the second. Let's assume that
your rate changes in the first year by 2 percentage points,
but your payments can increase by no more than 7 1/2% in any
one year. Here's what your payments would look like:
ARM Interest Rate Monthly Payment
First year @10% $570.42
2nd year @ 12% (without payment caps) $667.30
2nd year @ 12% (with 7 1/2% payment cap) $613.20
Many ARMs with payment caps do not have periodic interest
rate caps.
Negative Amortization
If your ARM contains a payment cap, be sure to find out about
"negative amortization." 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 long 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.
The next illustration uses the figures from the preceding
example to show how negative amortization works during one
year. Your first 12 payments of $570.42, based on a 10% interest
rate, paid the balance down to $64,638.72 at the end of the
first year. The rate goes up to 12% in the second year. But
because of the 7 1/2% payment cap, payments are not high enough
to cover all the interest. The interest shortage is added
to your debt (with interest on it), which produces negative
amortization of $420.90 during the second year.
Beginning Loan Amount = $65,000, Loan amount at the end of first year = $64,638.72, Negative Amortization during 2nd year = $420.90
Loan amount @ end of 22nd year = $65,059.62 ($64,638.72 +
$420.90)
(If you sold your house at this point, you would owe almost
$60 more than the amount you originally borrowed.)
To sum up, the payment cap limits increases in your monthly
payment by deferring some of the increase in interest. Eventually,
you will have to repay the higher remaining loan balance at
the ARM rate then in effect. When this happens, there may
be a substantial increase in your monthly payment.
Some mortgages contain a cap on negative amortization. The
cap typically limits the total amount you can owe to 125%
of the original loan amount. When that point is reached, monthly
payments may be set to fully repay the loan over the remaining
term, and your payment cap may not apply. You may limit negative
amortization by voluntarily increasing your monthly payment.
Be sure to discuss negative amortization with the lender
to understand how it will apply to your loan.
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: Some agreements may require
you to pay special fees or penalties if you pay off the ARM
early. Many ARMs allow you to pay 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.
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. Before you actually
apply for a loan and pay
a fee, ask for all information the lender has on the loan
you are considering. It is important that you understand index
rates, margins, caps, and other ARM features like negative
amortization. You can get helpful information from advertisements
and disclosures, which are subject to certain federal standards.
Advertising and ARM loans: Your first information
about mortgages probably will come from newspaper advertisements
placed by builders, real estate brokers, and lenders. While
this information can be helpful, keep in mind that the ads
are designed to make the mortgage look as attractive as possible.
These ads may play up low initial interest rates and monthly
payments, with out emphasizing that those rates and payments
could later increase substantially. Get all the facts.
A federal law, the Truth in Lending Act, requires mortgage
advertisers, once they begin advertising specific terms, to
give further information on the loan. For example, if they
want to show the interest rate or payment amount on the loan,
they must also tell you the annual percentage rate (APR) and
whether that rate may go up. The annual percentage rate, the
cost of your credit as a yearly rate, reflects more than just
a low initial rate. It takes into account interest, points
paid on the loan, any loan origination fee, and any mortgage
insurance premiums you may have to pay.
Banklady TIP: Ads may play up low initial rates so
always know your facts!
Disclosures From Lenders
Federal law requires the lender to give you information about
adjustable-rate mortgages, in most cases before you apply
for a loan. The lender also is required to give you information
when you get a mortgage. You should get a written summary
of important terms and costs of the loan. Some of these are
the finance charge, the annual percentage rate, and the payment
terms.
Selecting a mortgage may be the most important financial
decision you will make, and you are entitled to all the information
you need to make the right decision. Don't hesitate to ask
questions about ARM features when you talk to lenders, real
estate brokers, sellers, and your attorney, and keep asking
until you get clear and complete answers. The checklist at
the end of this document is ntended to help you compare terms
on different loans.
Terms:
Annual Percentage Rate (APR) A measure of
the cost of credit, expressed as a yearly rate. It includes
interest as well as other charges. Because all lenders follow
the same rules to ensure the accuracy of the annual percentage
rate, it provides consumers with a good basis for comparing
the cost of loans, including mortgage plan.
Adjustable-Rate Mortgage (ARM) is a mortgage
where the interest rate is not fixed, but changes during the
life of the loan in line with movements in an index rate.
You may also see ARMs referred to as AMLs (adjustable mortgage
loans) or VRMs (variable-rate mortgages).
Assumability When a home is sold, the seller
may be able to transfer the mortgage to the new buyer. This
means the mortgage is assumable. Lenders generally require
a credit review of the new borrower and may charge a fee for
the assumption. Some mortgages may not be transferable to
a new buyer. Instead, the lender may make you pay the entire
balance that is due when you sell the home. Assumability can
help you attract buyers if you sell your home.
Buydown With a buydown, the seller pays
an amount to the lender so that the lender can give you a
lower rate and lower payments, usually for an early period
in an ARM. The seller may increase the sales price to cover
the cost of the buydown. Buydowns can occur in all types of
mortgages, not just ARMs.
Cap A limit on how much the interest rate
or the monthly payment can change, either at each adjustment
or during the life of the mortgage. Payment caps don't limit
the amount of interest the lender is earning, so they may
cause negative amortization.
Conversion Clause A provision in some ARMs
that allows you to change the ARM to a fixed-rate loan at
some point during the term. Usually conversion is allowed
at the end of the first adjustment period. At the time of
the conversion, the new fixed rate is generally set at one
of the rates then prevailing for fixed-rate mortgages. The
conversion feature may be available at extra cost.
Discount In an ARM with an initial rate
discount, the lender gives up a number of percentage points
in interest to give you lower rate and lower payments for
part of the mortgage term (usually for one year or less).
After the discount period, the ARM rate will probably go up
depending on the index rate.
Index is the measure of interest rate changes
that the lender uses to decide how much the interest rate
on an ARM will change over time. No one can be sure when an
index rate will go up or down. Some index rates tend to be
higher than others, and some more volatile. (But if a lender
bases interest rate adjustments on the average value of an
index over time, your interest rate would not be as volatile.)
You should ask your lender how the index for any ARM you are
considering has changed in recent years, and where it is reported.
Margin The number of percentage points the
lender adds to the index rate to calculate the ARM interest
rate at each adjustment.
Negative Amortization - Amortization means
that monthly payments are not large enough to pay the interest
and reduce the principal on your mortgage. Negative amortization
occurs when the monthly payment does not cover all of the
interest cost. The interest cost that isn't covered is added
to the unpaid principal balance. This means that even after
making many payments, you could owe more than you did at the
beginning of the loan. Negative amortization can occur when
an ARM has a payment cap that results in monthly payments
not high enough to cover the interest due.
Points A point
is equal to one percent of the principal amount of your mortgage.
For example, if you get a mortgage for $65,000, one point
means you pay $650 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. These points usually are collected at closing
and may be paid by the borrower or the home seller, or may
be split between them.
ARM MORTGAGE CHECKLIST
Ask your lender the following questions:
- Fixed-rate annual percentage rate ?
- The cost of your credit as a yearly rate which includes
both interest and other charges?
- ARM annual percentage rate?
- Adjustment period?
- Index used and current rate?
- What is the Margin?
- Initial payment without discount?
- Initial payment with discount (if any)?
- How long will the discount last?
- Interest rate caps: periodic overall?
- Payment caps?
- Negative amortization?
- Convertibility or prepayment privilege?
- Initial fees and charges?
- Monthly Payment Amounts: What will my monthly payment
be after twelve months if the index rate stays the same?
- If index rate goes up 2%?
- goes down 2% ?
- What will my monthly payments be after three years if
the index rate stays the same?
- goes up 2% per year?
- goes down 2% per year?
Also, take into account any caps on your mortgage and remember
it may run 30 years.
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