Home Equity Loan
Adjustable Rate Mortgage
An adjustable rate mortgage or variable rate mortgage is a loan
secured on a property (house) whose interest rate and so monthly repayment vary
over time. Other forms of mortgage loan include interest only mortgage, fixed
rate mortgage, Negative amortization mortgage, discounted rate mortgage and
balloon payment mortgage. Adjustable rates transfer part of the interest rate
risk from the lender to the borrower. They can be used where unpredictable
interest rates make fixed rate loans difficult to obtain. The borrower benefits
if the interest rate falls and loses out if interest rates rise.
Variable rate mortgages are the most common form of loan for house purchase in
the United Kingdom but are unpopular in some other countries. Variable rate
mortgages are very common in Australia and New Zealand. For those who plan to
move within a relatively short period of time (three to seven years), they are
attractive because they often include a lower, fixed rate of interest for the
first three, five, or seven years of the loan, after which the interest rate
fluctuates.
Adjustable rate mortgages, like other types of mortgage, may offer the ability
to repay principal (or capital) early without penalty. Early payments of part of
the principal will reduce the total cost of the loan (total interest paid), and
will shorten the amount of time needed to pay off the loan. Early payoff of the
entire loan amount (refinancing) is often done when interest rates drop
significantly.
Adjustable rate mortgages are sometimes sold to unsophisticated consumers who
are unlikely to be able to repay the loan should interest rates rise, which they
often do. In the United States, extreme cases are characterized by the Consumer
Federation of America as predatory loans. Protections against interest rate
rises include (a) a possible initial period with a fixed rate (which gives the
borrower a chance to increase his/her annual earnings before payments rise); (b)
a maximum (cap) that interest rates can rise in any year (if there is a cap, it
must be specified in the loan document); and (c) a maximum (cap) that interest
rates can rise over the life of the mortgage (this also must be specified in the
loan document).
The Hybrid ARM
What is the difference between a hybrid and a traditional ARM
THE dominant loan product in today's marketplace. They are often packaged as the
5/1 ARM or the 2/28 ARM (most popular products). The loan is a "Hybrid" because
a true ARM adjusts for the same periods for the life of the loan, ie. a 6 Month
ARM is fixed for the first six months and adjusts every six months afterwards.
The 2/28 "Hybrid ARM" is a 6 month ARM that the borrower has purchased a "Rate
Lock" or introductory rate for the first 2 years (this is also done in 3,5,7
year fixed periods), and then the loan becomes a 6 month ARM thereafter, rather
than a loan that does only adjust every 2 years.
The benefits
This loan product has actually lowered the costs of borrowing in the early years
of loans, but certainly is a source of continuing refinance business to the
Mortgage industry. They let borrowers take advantage of special pricing, by
saving money on payments when the borrower's a) salary is rising such as for
young professionals or b) when the borrower knows they are going to move up
quickly from one home to another.
The risks
If a borrower is inconsistent in their on time payment history, afflicted by
tragedy which causes a credit problem, or keeps insufficient funds in reserve
(the payment savings from the lower rate for example), as referenced above, the
rates in Hybrid ARMs will certainly rise, and with insufficient credit and
income, the borrower may be forced to trade equity for time, and in some
markets, not as advantageously as today.
Terminology
Fully Indexed Rate - The price of the ARM as calculated by
adding Index + Margin = Fully Indexed Rate. This is the interest rate your loan
would be at without a Start Rate (the introductory special rate for the initial
fixed period). This means, your loan would be higher today if it was adjusting,
typically, 1-3% higher than the introductory rate. Calculating this is IMPORTANT
for ARM buyers, since it helps you predict the future interest rate of your
loan.
Margin - This refers to the banks profit margin above the value of
the financial index. The bank seeks to make a profit above the costs of
inflation. The index is a measure of the cost of funds as measured by inflation.
Index - A publicly published financial index such as LIBOR
(usually 1 month, 6 month or 12 month), 11th District Cost of Funds Index, MTA,
etc.
Start Rate - The introductory rate provided to purchasers of ARM
loans for the initial fixed interest period. The difference between the "Start
Rate" of an ARM and the rate of a fixed terms loan is that the "Start Rate".
Period - This is the frequency of adjustments, the longer the rate
remains fixed, the better the loan is for the borrower. Typically, the shorter
this is the lower the rate, since there are more opportunities to adjust
upwards.
Floor - A clause that sets the minimum rate for the interest rate
of an ARM loan. Most loans come with a Start Rate = Floor feature, but this is
primarily for Non-Conforming (aka Sub-Prime or Program Lending) loan products.
This prevents an ARM loan from ever adjusting lower. An "A Paper" loan typically
has either no Floor or 2% below start.
Payment Shock - Industry term to describe the severe (unexpected
or planned for by borrower) upward movement of mortgage loan interest rates and
it's effect on borrowers. Sadly, for those that do not read this wiki entry or
who do read it but cannot understand it's contents, they may experience it, or
spend too much of their incomes to borrow on fixed terms only. See Caps below
Cap - Any clause that sets a maximum change for the interest rate
of an ARM loan.
Understanding Caps
"The Caps" - In industry slang, there you could ask for the Caps
of a loan, and if your broker or loan officer is intelligent enough to read the
rate sheets they are quoting from, it is ALWAYS displayed and available. This is
basic stuff, the ABC's of mortgage lending, if you're working with someone that
can't or won't explain this to you, go elsewhere.
What's better? - The lower these numbers are, the better for you,
especially, the first number.
Examples: 2/2/5 ; 5/2/5 ; 2/1/6 ; 3/1/6 ; 2/4 ; 1/1/5 .
The first number is the initial change cap, the second is the periodic cap, the
last is the life cap. When only two values are given, this always means the
initial change cap and periodic cap are the same. The longer the initial fixed
period, typically, the higher the caps are given.
Initial Change Cap - ARM loans have a specified maximum first
adjustment that is typically higher than allowed on subsequent changes.
Periodic Change Cap - The maximum interest rate adjustment for
every subsequent periodic adjustment.
Life Cap (Ceiling) - The maximum upwards adjustment of an ARM loan. Typically on
first mortgages no more than 6%.
Crucial Information About Caps
Loan caps provide payment protection against payment shock. Most First Mortgage
loans have a 5% or 6% Life Cap. Higher risk products, such as Monthly Adjustable
loans with Negative amortization and Home Equity Lines of Credit aka HELOC have
different ways of structuring the Cap than a typical First Lien Mortgage.
First Lien Caps with no Negative amortization
Most First Mortgage loans have a 5% or 6% Life Cap. If the adjustment period is
6 months or 1 year ( the two most common periods on the market), then it takes
anywhere from 2-4 maxiumum upward adjustments to reach this cap
Negative amortization ARM caps
See the complete article for the type of ARM that NegAM loans are by nature.
Most of them are Monthly Adjustable ARMs and the life cap or ceiling is simply
expressed as a maximum rate, usually 9.95% or 10.95% these days. Beware though,
some of these loans have 14-16% ceilings, you have to ask . . . . The fully
indexed rate is always listed on the statement, but borrowers are shielded from
the full effect of rate increases by the minimum payment, until the loan is
recast
Home Equity Lines of Credit HELOC
Since HELOCs are intended by banks to primarily sit in second lien position,
they normally are only capped by the maximum interest rate allowed by law in the
state they are issued in! In Florida, for example, this is 18% ! Wow!
Sadly, most people do not take the time to learn about their ARM product, and
some people even take these loans out as their First Lien loan, putting their
house in jeopardy of foreclosure if there is an inflationary market.