Features of Adjustable Rate
Loans
An adjustable
rate mortgage (ARM) is a mortgage for
which the interest rate is not fixed,
but changes during the life of the
loan in line with movements in an
index rate. Such loans are also
referred to as adjustable mortgage
loans (AMLs) or variable-rate
mortgages (VRMs).
Lenders
generally charge lower initial
interest rates for ARMs than for
fixed-rate mortgages. The lower rate
may provide you with lower cash
outlays in the first year of the loan
and in the years thereafter should
rates remain relatively stable or
decrease. Additionally, you may be
able to qualify for a greater amount
under an ARM program than a fixed rate
program.
Rates have
decreased in recent years, and many
adjustable rate holders have been net
gainers. (See Interest Rate and
Payment Adjustment Illustration for an
example of an ARM utilized from 1980
to 1994).
Nevertheless,
interest rates may increase, leading
to higher monthly payments in the
future. You face a trade-off; you
obtain a lower rate with an ARM in
exchange for assuming more risk. The
information which follows should help
you evaluate and understand the risks.
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Adjustment
Periods
The interest
rate and monthly payment of most ARMs
change every year, every three years,
or every five years. The period
between one rate change and the next
is called the adjustment period. Thus,
a loan with an adjustment period of
one year is called a one-year ARM, and
the interest rate can change once
every year.
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 savings and loan
associations. 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.
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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.
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.
Additionally,
very large discounts are often
arranged by the seller. The seller
pays an amount to the lender, who then
provides you a lower rate and lower
payments early in the mortgage term.
This arrangement is referred to as a
"seller buydown." Utilizing
such, the seller may increase the
sales price of the home to cover the
cost of the buydown while actually
decreasing the buyer's monthly
payment.
To illustrate
how a discount might work, assume the
one-year ARM rate (index rate plus
margin) is at 10%. Your lender is
offering an 8% rate for the first
year. With the 8% rate, your first
year monthly payment would be $476.95.
However, the first adjustment of your
loan may increase your payment
substantially:
ARM Interest Rate Monthly Payment
First year (with discount) at 8%
$476.95
2nd year at 10% $568.82
Note that, although the index rate did
not change, the monthly payment
increased from $476.95 to $568.82 in
the second year. If the index rate
increases 2% in one year and the ARM
rate rises to a level of 12%, the
payment increases almost $200:
ARM Interest Rate Monthly Payment
First year (with discount) at 8%
$476.95
2nd year at 12% $665.43
To protect
borrowers from extreme increases in
monthly payments, most ARMs have
ceiling, or "caps", and many
allow borrowers to convert to a
fixed-rate mortgage. Should you
convert, the new rate is generally set
at the current market rate for
fixed-rate mortgages.
An
interest-rate cap places a limit on
the amount your interest rate can
increase. Interest caps come in two
versions:
•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.
The following example illustrates an
ARM with a periodic interest rate cap
of 2%. At the first adjustment, the
index rate increases 3%:
ARM Interest Rate Monthly Payment
First year at 10% $570.42
2nd year at 13% (without cap) $717.12
2nd year at 12% (with cap) $667.30
Difference due to cap: $49.82
A 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. Such may occur
after an interest rate cap has been
holding your interest rate down below
the sum of the index plus margin.
The example
below illustrates a periodic cap of 2%
with an index which increased 3% at
the first adjustment. If the index
remains the same in the third year,
your rate would go up to 13%:
ARM Interest Rate Monthly Payment
First year at 10% $570.42
If index rises 3%
2nd year at 12% (with 2% rate cap)
$667.30
If the index stays the same
for the 3rd year at 3% $716.56
Result: Although the index stays the
same in 3rd year, payment increases
$49.26
Therefore, as
a general rule, 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.
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 7.5%
payment cap, a payment of $100 could
increase to no more than $107.50 in
the first adjustment period, and to no
more than $115.56 in the second.
Assuming your
rate changes in the first year by 2
percentage points, your payments can
increase by no more than 7˝% in any
one year as follows:
ARM Interest Rate Payment
First year at 10% $570.42
2nd year at 12%
(without payment cap) $667.30
2nd year at 12%
(with 7.5% payment cap) $613.20
Difference in monthly payment:
$54.10
Negative
Amortization
Should your
monthly mortgage payments not be large
enough to pay all of the interest due
on your mortgage due to a payment cap,
negative amortization may occur.
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.
If your ARM
allows for negative amortization, the
interest shortage in your payment will
be automatically added to your debt,
and interest may be charged on that
amount. Your mortgage balance
increases, and you may owe the lender
more later in the loan term than you
did at the start.
This final
illustration uses the figures from the
preceding example to show the effect
of negative amortization 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
increased rate of 12% in the second
year results in a payment higher than
the 7˝% payment cap. The capped
payments are not large enough to pay
the interest owed. The interest
shortage, upon which you also pay
interest, is added to your debt,
producing negative amortization of
$420.90 during the second year.
Beginning Loan Amount $65,000.00
Loan amount at end of first year
$64,638.72
Negative amortization during 2nd year
$420.90
Loan amount at end of 2nd year
$65,059.62
(If you sold your house at this point,
you would owe approximately $60 more
than the amount you originally
borrowed.)
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