UNDERSTANDING ADJUSTABLE RATE MORTGAGE LOANS (ARMs)

Adjustable Rate Mortgages (ARM) offered by lenders have periodic rate changes, usually in relationship to an index, and payments may increase or decrease accordingly.

Most adjustable rate mortgages offer low introductory rates or "start" rates (can be as low as 5% below the current market rate of a fixed rate loan). This introductory start rate is usually good for one (1) month to as long as 10 years. Generally, however, the lower the start rates the shorter time before the loan makes its first adjustment.

The adjustable rate mortgages generally start at an interest rate that is 2-3 percent below a comparable fixed rate mortgage and change at specified intervals depending on the changing market conditions. Should the market condition change (interest rates go up) your payment goes up, and if the interest rates fall, your payment goes down as well. The adjustable rate mortgage could be less expensive over a long period of time than a fixed rate mortgage if interest rates remain steady or move slightly lower.

The borrower must weigh the possibility that the increase of interest rates could increase the monthly payments greater then affordable. But again, it is a trade off with an ARM for assuming a greater risk. Compare the indexes from each lender. Some of them are higher then others, and the lower the index (and margins) the lower your payments are. Make sure to discuss the margins, indexes, caps (annual) and other aspects of the ARM with your lender.

The most common type of adjustable rate mortgages (ARMs) are:

1. 30 - year adjustable adjust monthly for the entire term of the loan

2. 15 - year adjustable same as the 30 year adjustable

3. 5 - year adjustable same as the 30 year and 15 year adjustable

4. 1 - year adjustable Adjusts once a year

5. 6 month adjustable Adjusts every 6 months

6. 3 month adjustable Adjusts every 3 months

7. 3/1 adjustable Fixed for the first 3 years, then adjusts yearly

8. /1 adjustable Fixed for the first 7 years, then adjusts yearly

Each adjustable rate program listed above have indexes, margins, cap rates (annual, life and/or payment caps) start rates and conversion options. As you can see, with the list of adjustable rate mortgage programs above, there is a possibility of over 14,000 loan programs to select from.

With a lower interest rate that the ARM programs offer (some lenders offer lower rates than the sum of the index and the margin. These rates are called discounted rates, and are often associated with large initial loan fees "points" and much higher interest rates after the discount expires), this could mean you may qualify for a larger loan amount (larger home purchase price). The ARM could be less expensive over a long period of time (over a fixed rate mortgage) if the interest rates remain at a constant level or if they decrease slightly.

If your income does not increase sufficiently to cover the increase in monthly payments on ARM loans, it could cause a financial situation that could force you to reconsider alternative options in your lifestyle. As an example: A $100,000.00 loan amount with a 5.5% start rate amortized over 30 years (an adjustable rate mortgage ARM) with a two (2%) annual cap (the cap is the maximum the interest rate can be increased each year, and for this example, assume the maximum cap was attained) the monthly payments would be $567.79.

Assume the borrower´s annual income was $48,000.00 and he will be getting a 2.5% annual raise ($48,000.00 times 2.5% equals $1,200.00 additional income ($100.00 per month).

If the start rate of 5.5% were increased by 2% (the maximum expressed in this example) then the new interest rate for the following year would be 7.5% and would have monthly principal and interest payments of $699.21.

The difference:

699.21

Less $567.79

Difference $131.42 per month

Less $100.00 pay raise (annual raise divided by 12 months) costs the borrower $ 31.42 per month (less to spend)

All Adjustable Rate Mortgages have the same basic elements, but to understand them, you must know the elements:

1. Indexes: Is the financial instrument lenders use to tie or adjust a loan and fluctuate up or down based on conditions of the financial markets. (The base number used to determine future note rate. The margin is added to the index to determine the note rate.)

a. Treasury Security (T-Bill) 6 months, 1 year, 3 year, 5 year (the most common is the 1 year T-Bill)

b. 11 the District cost of funds

c. 6 month CD (Certificate of Deposit)

d. LIBOR: 1 month, 3 month, 6 month and 1 year (London Interbank Offered Rate) with the most common being the 6- month for mortgages.

e. Prime Rate (Prime + 1, 2, or 3)

2. Margins: The fixed number, expressed in basis points, that when added to the index determines the note rate (interest rate you pay) on a loan and is referred to as the fully indexed rate. Margins usually range from 1.750% and increase to 6.00 in increments of .125% depending on the index and the amount financed in relation to the property value and profit the lender wants to make. Margins that are 3.75 and above, are usually for C and D type borrowers and adjustable 2nd trust deeds.) There are approximately 20 possible combinations of margins.

3. Start Rates: Start rates will usually start off as low as 4.25% and will increase to approximately 9.5% for Jumbo loans. These rates are usually increased by .150% and there are no set guidelines as to the type of loan programs from lender to lender.

4. Life caps: (A number that when added to either the initial note rate or subsequent note rate determines the maximum note rate of a loan, usually for the life of the loan. Life caps are typically 4%, 5%, and 6%.) Loans that offer low margins usually have higher lifetime caps. Life caps vary from lender to lender and from loan program to loan program.

5. Annual cap: The maximum amount of interest that a loan can increase in a year. There are two types of Annual Caps: 1) interest percentage cap; 2) payment cap. Both types of caps make a difference as to the actual monthly payment increase or decrease.

A) Payment caps reduce the payment shock in a rising interest rate market, but they can also lead to deferred interest or "negative amortization" (owing more money on the mortgage than originally borrowed). The payment caps are usually 7.500% of the previous payment. Payment caps limit the increase in monthly mortgage payments by deferring some of the increase in interest.

When negative amortization equals 125% of the original loan amount ($100,000 loan amount times 125% equals $125,000) the loan balance is recalculated so as the monthly payments will pay off the loan balance over the remaining life of the loan. Be sure to discuss the negative amortization (if any) with your lender to understand any effects it may have on your loan.

B) Annual caps are usually expressed as 1% or 2% annual caps. An example of the two Annual Caps:

100,000 Loan @ 6%: $599.55 monthly payments.

1% interest rate cap = 7%: $665.30 new payments.

1% payment cap: $605.55 new payments

A possible negative of: $ 59.75 per month.

6. Note Rate: The base rate of interest that will determine the effective cost of the loan to the borrower not withstanding any other qualifying or payment rate.

7. Payment adjustment: The payment adjustment is the time when the monthly payments will increase or decrease. These payment adjustments can be: 3 months, 6 months, 9 months, or once a year on the anniversary date of the loan.

8. Convertible: A provision that allows for an adjustable loan to be converted to a fixed rate loan. These convertibles will very from lender to lender, but as a general rule, the borrower has the option to convert his adjustable loan to a fixed loan on the anniversary date of his loan for a fee, and usually is offered for a 3-year period in which the borrower may elect to convert.

Adjustable rate mortgage (ARM) loans can be an advantage to some homebuyers. But if your income is not going to increase sufficiently enough to offset the potential increase in monthly mortgage payment (principal and interest) you may want to reconsider your buying power by contemplating the purchase of a lesser priced home.

If you are purchasing the home to fix up, want to sell it in a year or so and want to have lower payments in the early part of the loan, then the ARM may be the best for you.

If you are a professional that receives annual bonuses and you want to have the lower payment during the early years of the loan and perhaps apply you bonus toward the principal balance, this could very well be the better loan program for you.

In order to determine if an ARM is the right choice for you, you must look at all aspects of the options available to you.

Some adjustable mortgages involve negative amortization (owing more on the original loan amount than started with) during the early years because of the lower monthly mortgage payment does not cover the full amount of the loan interest payments. In that case, the loan balance will increase during the early years of the mortgage.

As the negative interest increases over the period of the loan life, the negative that has accumulated will be paid off over an amortized period. Once the loan balance has reached 125% of the original loan amount, the loan will be re-amortized for the balance of time remaining. As an example: If the loan was 30 years amortized, and the negative reached 125% in year 6, the remaining time on the loan, 24 years, is the new amortized period. The new period of time would determine the new monthly payment.

Questions to ask yourself about adjustable mortgages:

1. How long do you plan to stay in the property?

2. Do you want your loan to be assumable some time in the future?

3. Is the purchase a rental property, and you want to have a possible positive cash flow during the early years of the mortgage?

4. What are the possible tax benefits with write-offs, if any, with a lower interest rate now, compared to a higher fixed rate interest write off?

5. Is your income increasing or stable? (Receive annual bonus, cost of living increases, or on commissions)

6. Do you want more spendable cash now? (Adjustable mortgages have lower monthly payments during the early years of the loan compared to fixed rate mortgages)

7. Is it easier for you to qualify for the loan because of the lower start or qualifying rate? (Will your income increase substantially as the mortgage payments increase)?

8. How much of a monthly savings is there between a fixed and an adjustable loan? (How long will it take to balance out the difference between fixed rates and adjustable rates-3, 4, or 5 years?)

9. What can you do with the difference of savings between the two types of loans?

10. Can you invest the difference of monthly payments to offset the higher lifetime cap rate over a fixed rate mortgage? (What type of investments have you looked into: Trust Deeds, Bonds, other real estate, and high yield securities?)

Lending institutions are offering various combinations of payments. It is best to check with your lender to see what is available.

With the frequency of interest changes and the maximum increase in rate, there are legal consumer safeguards in effect on both the above; not only for each change, but for the life of the loan.