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Mortgage 101 - 3/1... 5/1... 5/25... What?
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Adjustable Rate Mortgage?
Adjustable rate mortgages become more popular as interest rates rise,
and for good reason–they make sense. They are, however, not without an
element of risk.
When interest rates are
low…
* The spread between adjustable rate and fixed-rate
mortgages is small.
* The likelihood of the adjustable rate increasing
is relatively high.
* Most borrowers prefer the safety and value of a
fixed-rate loan.
When interest rates
increase
* The spread between adjustable rate and fixed-rate
mortgages is greater.
* The likelihood of the adjustable rate increasing
is diminished, and the likelihood of a lower rate improves
* The advantages of an adjustable rate become more
desirable
Types
of ARMs
Many borrowers think of adjustable rate loans as the traditional 1/1,
where the initial rate is guaranteed for only a year, and the rate
adjusts each year thereafter. While the 1/1 options typically provides
the lowest first-year rate, its higher volatility must be carefully
considered.
There is a wide variety of adjustable rate mortgages (ARMs). For
example, a 1/1 ARM means the initial rate is guaranteed for one year,
and the rate adjusts every year thereafter. You may prefer to choose a
3/1 ARM, where the initial rate is guaranteed for 3 years, then adjusts
every year thereafter. Depending on the loan you choose, you may be
able to select from the following menu: 1/1, 3/1, 5/1, 7/1, 10/1. All
these loans are typically based on a 30-year amortization.
Index
and Margin
The rate adjustments are based on two factors: the INDEX and the
MARGIN. Many ARM products are based on the weekly average yield of the
US Treasury Securities, adjusted to a constant one-year maturity (the
index), plus the margin. Some ARMs have a different index.
For example, suppose a borrower has a 3/1 ARM based on the weekly
average of US Treasury Securities and a margin of 2.75%. Beginning with
the fourth year, the interest rate will adjust. If the US Treasury
Index is at 5.50% and the margin is 2.75%, the new interest rate will
be 8.25% (5.50+2.75=8.25). Each year thereafter the rate will adjust
based on the US Treasury.
Remember, the initial rate of an ARM is usually lower than the current
“index + margin” rate. Thus, with no change in the underlying index
rate, the first adjustment will likely be upward. However, if interest
rates decline, there may be a rate decrease.
Rate
Caps
Borrowers aren't completely unprotected during the rate adjustments.
Each ARM has a number of limitations on rate adjustments.
Lifetime
Cap: The maximum increase the interest rate can adjust over the
life (term) of the loan. For example, if the initial rate is 7.5% and
the lifetime cap is 6%, the rate may never climb above 13.5%.
First
Adjustment Cap: The maximum increase that can take place on the
first adjustment made to the interest rate of the loan. For a 3/1 ARM,
this adjustment is made at the beginning of the fourth year. It may be
as low as 1% or as high as the lifetime cap (typically 6%). Be sure
your lender tells you this information.
Adjustment
Cap: Following the first adjustment, this is the maximum the
rate can increase or decrease at each subsequent adjustment of the
loan. Usually the adjustment caps are 2% on conventional loans and 1%
on FHA loans.
Floor: This is the lowest the rate can go, and it varies with the ARM
product.
Convertibility
Many adjustable rate loans have a convertibility feature, allowing the
borrower to convert the adjustable rate to a fixed-rate for the
remainder of the loan term. Terms for the convertibility vary among
ARMs, but many are based on the current FNMA yield plus a small margin.
Others are based on the current rate of the ARM. The specific windows
of opportunity when the loan can be converted vary with the variety of
ARM products. Although there is usually a fee associated with the
conversion, it's far less than the cost of a new loan and no
re-qualification is required. ARMs with a convertibility feature often
cost slightly more than ARMs without the convertibility feature.
Prepayment
Penalty
Some ARMs may have a prepayment penalty in exchange for a lower rate.
The penalty is usually eliminated after 3 to 5 years, but varies among
ARM products. If you're confident you'll keep the loan longer than the
prepayment penalty applies, the advantages of the lower rate may make
sense for you. Be sure you know if your loan has a prepayment penalty.
Why
Choose an ARM?
There are a number of reasons to choose an ARM. Your best source of
information is your Loan Officer, but a brief summary follows:
Advantages of an ARM
- It usually increases the level of borrower
qualification (you can afford more home).
- It provides a lower initial rate. Works well for
people who expect an increase in income.
- It provides a lower rate than a fixed-rate loan. If
interest rates decline, the rate will improve (while those who chose a
higher, fixed-rate at the higher rate.) An ARM makes sense if the
borrower believes interest rates will remain stable or decline by the
time the initial ARM rate expires. An ARM also makes sense for
borrowers who believe they will move (sell the property) before the
initial rate expires. Finally, an ARM makes sense for those who want a
lower rate now, and who plan to convert to a fixed-rate or refinance
when the rates decline.
- A little-understood feature of an ARM is the
procedure for calculating payments. Each time the rate is adjusted, the
loan is re-amortized over the remaining term of the loan. For those who
plan to make a substantial "bulk" contribution to the principal balance
in the future, the result is different than with a fixed-rate loan. For
example, suppose one borrower has a fixed-rate loan for $100,000 and
another borrower has an ARM for $100,000. Both borrowers inherit
$25,000 and want to pre-pay the loan. The fixed-rate borrower will not
see a difference in the monthly payment, but will have the loan term
shortened considerably. The ARM borrower will see a substantial
reduction in the payment at the next adjustment, but the term of the
loan remains the same.
An Adjustable Rate Mortgage makes sense for many people when interest
rates are relatively high. Discuss your objectives and needs with a
Loan Officer to determine if an ARM can save you money.
My mortgage team
remains up-to-date with the various
mortgage rates, options, loan choices and alternatives and are an
invaluable resource for any home buyer or home owner who is considering
refinance.
We are committed to providing you with mortgage services
that exceed your expectations.
Feel free to
browse my decision-making
tools and calculators.
When you are ready
to discuss mortgage options give us a call. (916)
899-4839
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