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Adjustable Rate MortgagesIf it were necessary to divide mortgages into two broad
categories, it would be logical to divide them into
fixed rate mortgages and
adjustable rate mortgages.
During the 80's,
interest rates became more stable and averaged
about 11.9% and then began to drop steadily to about 8.8% by 1989.
Adjustable rate loans or variable rate loans carry an interest rate that adjusts at predetermined intervals throughout the life of the loan. Rates of these loans can average 1-4 percentage points below the rate of a 30-year fixed rate mortgage, but they offer less security when compared to a fixed rate loan. The adjustment rate interval is usually specified in the loan contract. A mortgage that adjusts yearly is called a 1-year ARM and reflects the rates in the chart above. A second type of ARM is a 3 year adjustable rate mortgage. This mortgage class adjusts at the end of your first 3 years and adjust in 3-year intervals over the life of the loan. ARM's are tied to an index of leading economic indicators and many are tied directly to 3-year or 5-year treasury notes. Other ARM's may be tied to the Federal Housing Finance Board's Average Contract Mortgage Rate or the Federal Cost of Funds Index (COFI), the London Interbank Offer Rate (LIOR) or others. In accepting a mortgage using one of these indexes, make sure you know which index is to be used and do your Homework regarding the history of the Index. Some indexes are more volatile than others. During periods of high inflation and low interest rates, your ARM could move in the opposite direction of the average Mortgage rate. Find out which index your ARM is tied to and how often it changes. Also look at the history of the index for prior volatility and research future forecasting of the index. You can usually do your Homework on the volatility history of the index that your lender uses by contacting Fannie Mae's Yield and Commitment Information Hotline (800-752-7020). The loan rate and the index rate may move upward or downward together but they are not necessarily the same. The lender may add "margin" to the index to obtain a competitive interest rate. This "adjustment margin" is the profit margin of the lender and it may average 1-3% above the indexed rate. Make sure you understand what this margin amount is and whether it remains constant over the life of the loan. To obtain your interest rate, you would take the specified index and add the margin amount to this rate to obtain your current interest rate. In some cases, the interest rate of an ARM may be somewhat different on the front end of the mortgage and may be described as a "Promotional Rate". The lenders margin may be a negative number below the index specified. Each of us has had experience with credit card companies that offer a 3-4% promotional interest rate to encourage you to transfer balances from one credit card to another. At the end of the promotional term, the rate may change to 21%. Make sure you understand what the margin is at the time of the loan closing and what the index will convert to once the promotional period is over. This change in margin rate can affect your monthly mortgage payment and squeeze your family budget. There are a number of protection features offered by ARMS that make adjustable rate mortgages attractive and these features are a key consideration in shopping for an ARM. Payment caps and interest rate caps are two such securities. Payment caps for better or worse may be a good situation for some borrowers. In payment cap situations, your payments are capped based on a percent of last payment. This can provide a false sense of security. In unusual situations, you may not lose your house due to the inability to make monthly payments, but if rates increase too dramatically, you may not ever be able to pay-off your mortgage. This situation occurs when negative amortization occurs. Rising interest rates put you into a situation where your monthly payment does not cover the increased costs of rising interest rates and negative amortization occurs. In this case, you loan balance amount can continue to grow and get larger instead of smaller. In our opinion, payment caps are generally a bad idea for borrowers during periods of increasing interest rates. A much better scenario is an interest rate cap. Currently, by law all new ARM's must contain a lifetime cap clause, but the law does not establish a specific maximum rate for the increase. Some ARM's may entitle you to decreases in interest rates, as well. Most ARM's establish a 5-6% maximum interest rate increase range. This is a primary reason why shopping for an ARM is especially important. At first glance, a low initial term ARM may cost you money in the long-term. There are other variations in interest rate caps, as well. Periodic caps may limit the amount of increase from one accrual period to the next. Periodic caps are generally a good idea because during periods of volatility, where interest rates escalate rapidly, a periodic cap limitation could mean the difference between making a slightly increased payment or losing your home. Generally all ARM's offered on the market offer both a life-time and periodic cap on interest rates. Because of this, most ARM's are sold by the loan originators. If you decide that an adjustable rate mortgage is the right decision for you, you should ask whether the loan is assumable, convertible, and is there a prepayment penalty. An assumable loan can be an advantage if you decide to sell your home before the loan reaches its conclusion. During the 1970's my father was able to assume a low interest loan during a period when interest rates were astronomical. This saved him the closing costs on a new loan and allowed him to keep the low interest rate. The seller took his down-payment and was able to get out from under a difficult payment and housing repairs. My father then rented the property back to the former owner for the monthly payment on the mortgage. Today after about 10 successive renters, the property is paid off and has a positive cash flow. An assumable loan allows you to transfer the loan to another buyer under the same terms, but generally, the lender must approve the new buyer and transfer responsibility for the debt to the new owner. The buyer assumes primary liability for the remaining debt and the seller is removed from the loan responsibility. Convertibility of an adjustable rate mortgage is always a nice option. In this instance the buyer can transfer the ARM to a fixed rate mortgage. If the mortgage market has been falling consistently, this is one of the primary benefits that you can receive from an ARM. Let's assume that you have an ARM that is convertible and after 7 years the rate has fallen to a point that locking in a fixed rate mortgage will save you money over the long-term. Some ARM's purchased through Fannie Mae may allow you to convert your ARM to a 15-year or 30-year loan for as little as 1% origination fee plus $250. ARM's with a conversion clause typically cost a little more than a standard ARM. This may be a higher interest rate, a conversion fee on the date of the fixed rate loan closing, or it may be a flat fee which is paid upfront when you close on the ARM. In most case, convertibility is highly desireable and usually worth the extra cost, but each situation must be evaluated independently. Different Convertible ARM's may have different clauses, which may limit your ability or limit your window to convert to a fixed rate loan. Some may stipulate that the conversion may take place at any future day, while others may establish an option of converting the loan on the anniversary or at the end of the adjustment period. Another less desirable clause (for any loan) is a prepayment penalty. This clause limits your ability to pay off the loan or sell the home before the maturity date. Prepayment penalties generally benefit the lender and it assures the lender that the loan will be profitable for them. Over a given period they expect to earn a specific profit from the loan. The prepayment penalty assures them that they will earn the given margin dollars, whether the loan reaches its maturity date or not. Another type of ARM is a 3/1, 5/1, 7/1 or 10/1 loan. This ARM has appeal to many borrowers because the loan establishes a fixed rate for 3 (3/1), 5(5/1), 7 (7/1) or 10 (10/1) years and then adjusts at the end of the term. Often the borrower may be strapped for cash during the initial period of the loan and assumes that his/her earning potential will increase by the end of the fixed rate period. Longer term loans are especially attractive for those who never attend to carry the loan to its adjustment date, but borrowers should be wary of clause built into the loans that requires them to pay a penalty should they opt out on the renewal after the adjustment. From the opposite vantage point, some lenders may include an opt out clause for the lender. Lets assume that interest rates should temporarily bottom out at 3% on the adjustment date. An opt out clause would release the lender of the obligation to extend the loan if the rate falls below a specific level. Another consideration for you is to make sure there is a maximum cap established for the life of these loans over a 20-30 year period.A similar loan to the 3/1 loan is a two step mortgage, in that the rate is fixed for 7 years and then on the adjustment date, the loan resets for the remaining 23 year period at the competitive rate on the renewal date. The new rate may be tied to 10-year treasury securities plus margin for the lender. The advantage of this type of mortgage (while it may seem like rolling the dice) is typically borrower earnings increase during the initial 7-year term and payments are generally less during the reduced rate period of the initial term and these mortgages will accept as little as 10% down-payment which is ideal for younger home buyers. The disadvantage to a two step mortgage is you typically pay a higher interest rate of the term of the initial period and an interest rate increase during the final 23 year term could cost substantially more. Discount ARM's are mortgages offered at a rate that is discounted below the index measure plus margin for the lender. Similar to a promotional ARM, these loans provide the discounted rate for the initial term and adjust at the end of the initial term. Discount ARM's may carry substantial loan origination fees and additional points payment requirement, both of which add significantly to the cost of the loan. The extra points payment at closing acts in the same manner as buying down the interest rate. Often builders will use this type of loan in order to make an over-price home more attractive to buyers. These discount ARM's can be tricky and caution should be emphasized. In some cases, a interest rate cap may be imposed as required by law, but often the cap beginns at the conclusion of the initial adjustment term. A 5% loan (with buy down points added at closing may increase to 7-8% with a 5% cap. This could translate to a 12-13% rate over the final 23-25 years of the loan. The cap problem occurs because their may not be a cap on the initial term of the loan and a 5% initial term could increase to 12 or 13% and the 5% interest rate cap could be piled on top of this interest rate. Make sure all options are covered should you decide to use a discount ARM and be sure you read and understand all the fine print. 7-Year Balloon Mortgage Option - A balloon mortgage generally establishes a low monthly payment period for 7 years and the balance owed becomes due on the seven-year anniversary of the loan. A balloon mortgage may be a fixed or adjustable rate. Some Balloon mortgages carry a refinancing option. Most Fannie Mae loans are sold as ARM mortgages and carry a refinancing option. A commercial lender is generally under no obligation to assist with refinancing the remaining balloon balance. An advantage of a 7 year balloon is the interest rate like other ARM loans are lower than the rate that can be obtained with a 30 year mortgage. The monthly payments are calculated on a 30-year note at the reduced interest rate. For homebuyers who do not intend to remain in their current home for more than 7 years, this could be an attractive option. At the end of the 7-year period, the balance can be placed on a 20-30 year fixed rate note. This type of loan could be especially attractive to first-time buyers, since their earnings during the initial period of the loan is usually much less than later on. This allows the new homebuyer to build equity more quickly, at a lower interest rate, and allows them time to decide if their home purchase is the right decision. In addition, by using points to buy down the mortgage, the monthly payment option could be even more attractive. Besides the obvious negative, in the fact that interest rates may rise, another negative aspect of a balloon mortgage is you could lose your home and down payment if you are unable to meet the monthly payment requirement. Also, should your credit rating fall in disrepair, you may be unable to get financing for the remaining period of your mortgage. Finally, you must refinance at the end of the balloon period, which means you must pay closing costs again, which may include points, origination fee, home appraisal and other fees. Finally, these loans are typically financed at a rate higher than the current interest rate and may be as high as 4% more. It does, however, allow many home buyers a chance at living the American Dream by assisting with the down payment, when they could not otherwise. The no money down mortgage is a very real transaction that many creative finance professional have created for young home buyers. This mortgage is actually two mortgages - a fixed 30 year mortgage for 90% of the home loan value and a second mortgage to finance the remaining 10%. The second mortgage is typically an adjustable rate mortgage and is usually issued as a line of credit rather than a second mortgage. This is a good mortgage for younger, first-time home buyers and since the loan is in the form of a home mortgage, all interest can be used as an itemized deduction for your federal tax return.
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Helton Genealogical DNA Project - Hilton Family Tree - http://hiltonfamilytree.com
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During
the "Clinton Years" until 1997, interest rates steadily
declined and leveled off to average about 5.8%. During periods of interest
rate volatility or during a decline period, an ARM may be a wise investment.
During period of interest rate hikes, it may be best to attain a fixed rated
mortgage. Currently, during 2005, where interest rates are at 40-year
historic lows, you may be best suited for a 20 or 30-year fixed rate mortgage.
