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Mortgage: An Overview (Part 3 of 5)

Mortgages - An Overview (3): Adjustable Rate Mortgage

by Joseph Hughes

Adjustable rate mortgages (ARMs) were very popular over the last few years. They were also the loans that got so may people into trouble. One reason people got into trouble was that they didn’t understand the internal mechanics of that type of loan.

An ARM has a number of components, none of which are standardized. Most ARMs are 30 year loans. That is about the only thing that is standard. In addition to the term of the loan, the margin, index, interest rate caps, payment caps, interest rate caps, initial interest rate (sometimes known as a teaser rate), frequency of rate adjustment, and frequency of payment change all determine the amount that the borrower is paying at any time during the term of the loan.

The initial rate determines the payment at the beginning of the loan, but the two items are not necessarily related. The initial payment may be set artificially low and advertised to make the loan more attractive to prospective borrowers. If the initial payment rate and the actual rate are not the same, they will be eventually. The fine print of the note explains when that will happen. Negative amortization may, or may not, be an issue during the time the teaser rate is in effect. A quick note on negative amortization: One is not obligated to pay the low amount, which generates negative amortization. The option of paying more and not allowing the negative amortization to take place is always available..

The index is the base point of the interest rate of the mortgage. Usually one of three indices is used: LIBOR (London Inter Bank Offering Rate), the one year treasury rate, or the prime rate. They are three distinct indices, but, in general, they move in the same direction. The LIBOR has become popular because it allows the loans to be sold on the international market. When ARM loans first began the treasury security was the more popular index, but it has been supplanted by the more ubiquitous LIBOR. The prime rate is used mainly for home equity lines of credit (HELOCs), which enable the borrower to draw down on the equity in his home whenever he wants.

Once the index has been established then the margin, or spread, is added to it in order to determine the actual interest rate. The margin is administratively determined by the lender and generally ranges from two to three or three and a half per cent. The margin will be defined in the note and will remain constant over the life of the loan.

Caps, or limits, are placed on the interest rate when it adjusts. In addition, there will be a life-time cap above which the interest rate may not go even if the index plus the margin equal an amount that exceeds that cap. This life-time cap is defined in the note and it is usually a stated interest rate. But sometimes it may be defined in terms of a percentage over the initial fully indexed rate. For instance, the note may say that the interest rate charged on the note may never exceed a certain interest rate. Either way the life cap will be defined in the note.

The interest rate change cap is the maximum that the interest rate may go up, even if the index plus the margin spikes upward. This cap protects the borrower from payment shock, but it also functions as a floor as well, so that if the interest rate plunges downward, the interest rate can only go so low during one change period. In this way, the cap protects the lender from a rapid decrease in the income from the loan. Thus, the change cap gives built in protection for both borrower and lender.

Some ARM loans have a cap on how much the payment can increase, but have no cap on the interest rate when there is an adjustment. The borrower has a limit on the amount of payment, but none on the interest rate. This situation is confusing because there is the note rate for the loan, but there also may be a rate which determines the payment. If the borrower is paying less than the interest rate, the payment will not cover the required interest rate. Such a situation may result in negative amortization and is one of the terms to be aware of when reading the note.

The frequency of the interest rate change can also be an issue. The note may adjust monthly, every six months, annually, every two years, every three years, every five years, or every seven years. In general the shorter the period between adjustments, the lower the initial rate will be. The lender will do this to shorten the time he has to give the borrower the low rate. A common loan is one where the interest rate and payment are set for five years with the interest rate and the payment rate being the same. At the end of the five years, the rate adjusts every six months for the remaining life of the loan. So for 25 years the interest rate will adjust every six months in accordance with the terms of the note, index plus margin. This loan is relatively safe loan because it provides the borrower to have stability for the first five years.

People have gotten into trouble when they don’t understand the underlying dynamics of the loan they have. Often they have a loan that adjusts after the first month or first six months. The interest rate goes up on that adjustment, and then goes up again at the next adjustment and at the next adjustment. Then the borrower finds himself with a payment that is double what he started with a year before because he didn’t understand how the initial rate was determined or what was going to happen over the next six to 18 months. The borrower focused on the initial rate without paying attention to what was going to happen later. Though the dynamics may have been explained to him, the borrower focused on the initial payments, which were easy to handle.

When one considers all of the many and variable, even illogical, elements involved in an adjustable rate loan, the amount of consumer confusion is easy to understand. Most borrowers are not even aware of what these elements are, much less how they fit together and ultimately determine the interest rate and payment. Borrowers make many assumptions. And those assumptions will often, even usually, be wrong. An adjustable rate loan can be a good, even an ideal, loan for some borrowers who understand the internal dynamics, and what is going to happen and what he cannot know. But most people probably do not understand and should not take on this type of loan because they may find themselves in a financial situation they did not expect or understand, and can’t deal with.

Continue to the next article in the Mortgage: An Overview series