Discover the Language of Mortgage Lending
Adjustable Rate Mortgages
The information which follows
has been adapted from the "Consumer Handbook on Adjustable
Rate Mortgages" published by the Federal Reserve Board
and Office of Thrift Supervision.
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 on several ARMs have
dropped in recent years. 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 terms which follow
will help you understand some of the important concepts
involved with ARMs.
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.
Index
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.
Margin
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.
Therefore, in comparing ARMs,
look at both the index and margin for each plan. Some indexes
have higher average values, but they are usually used with
lower margins. Be sure to discuss the margin with your lender.
Initial Rate
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, the seller
often arranges very large discounts. 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.
Interest Rate Caps
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.
Payment Cap
Some Adjustable Rate Mortgages
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.
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.
Amortization Tables
The amortization tables allow
you to see a summary of unpaid principal, interest paid
and initial monthly payment for each year of the life your
loan.
Appraised Value
The appraised value is the
market price of the home you wish to buy. In some cases
you may pay more or less than the appraised value of the
home, but unless stated otherwise you may assume that the
appraised value of the home is also the purchase price.
This figure is used to determine
your down payment and whether or not you'll be required
to pay mortgage insurance.
Annual Percentage Rate (APR)
The cost of credit on a yearly
basis, expressed as a percentage. Required to be disclosed
by the lender under the federal Truth in Lending Act, Regulation
Z. Includes up-front costs paid to obtain the loan, and
is, therefore, usually a higher amount than the interest
rate stipulated in the mortgage note. Does not include title
insurance, appraisal, and credit report.
Appreciation Rate
Typically, the market value
of your home will increase over time. The appreciation rate
is a way to judge how quickly the home's value is increasing.
You may estimate this figure by calculating the percent
increase of the home's value over a period of one year.
Cost Analysis
In most of our calculation
programs, we usually include these items as costs:
The interest you pay
* The discount points you
pay
* The closing costs you pay
* The property tax and property insurance you pay
* The mortgage insurance you pay
We usually include these
items as benefits:
The tax savings you receive
from paying interest and discount points
* The tax savings you receive
from paying property taxes
* The appreciation (increase in the home's value) you gain
* The amount of principal you repay with each payment
In order to determine which
of your options will cost you the least over the period
of time you'll own a home, we compute for you the total
of the costs and benefits you'll pay or receive. The calculation
is a bit tricky because you'll receive or pay the items
above at various times: immediately, monthly, yearly, or
at the time you sell.
The time at which you pay
a cost or receive a benefit can make a big difference. For
example, receiving $5,000 right now is worth more to you
than receiving it 3 years from now. You can invest the $5,000
and earn interest over the 3 years. In the same way, if
you can avoid paying a cost for a while, you can invest
that amount now and earn a bit of interest on the money.
So, we use the interest rate
you probably receive on your savings and adjust each of
the items above, figuring out what each cost or benefit
would be worth to you today. We can then sum up all the
numbers and give you the total cost of each option as if
you paid it today.
The option with the lowest
cost is usually the best for you.
Discount Points
One discount point is equal
to 1% of your loan amount. On a 100,000 mortgage loan 1.5
discount points equals ($100,000 x 1.5%)=$1,500.
Discount points are paid to obtain a lower interest rate
on your mortgage. The more points you pay, the lower the
rate you may obtain. The longer you own your property and
continue to pay on the loan, the more likely it will be
that paying points will be advantageous for you. If you
intend to hold the mortgage for only a short period of time,
the cost you pay up front may exceed the benefit you will
receive from obtaining a lower rate.
Equity
Your equity in your home
is the difference between the remaining balance owed on
your mortgage loan and the appraised value of the home.
Your equity increases if your home increases in value and
as you make your monthly payments of principal and interest.
The principal portion of your payment is used to repay the
amount you borrowed.
Tax and Insurance Impounds
One month's worth of your
yearly tax bill and your yearly homeowner's insurance premium
will be added to your loan payments.
As an example, if your property taxes are $2,000 per year
and your insurance premium is $600, one month's worth (1/12th)
of each is $167 and $50.
The lender collects these
with your monthly payment and holds them in a special account
("an impound account"). The money in the account
will be used to pay your taxes and insurance premiums when
they become due.
Here's why taxes and insurance are collected along with
your principal and interest payments:
If your taxes are left unpaid,
your state can foreclose on your property in order to obtain
payment. If the foreclosure is successful, the lender could
lose his collateral. In other words, if you're not making
your payments, the lender could not recoup his loss: the
state's foreclosure would supercede his.
The lender also wants to
make sure your insurance premium is always paid. If your
property is destroyed by a fire, he'll have lost his collateral,
but his loan should be repaid by the insurance company.
Interest-Only Payments
Interest-only payments pay
only the interest you owe. They are not large enough to
pay back any of the initial amount you borrowed and you
do not earn equity in your home. If you want to pay back
what you've borrowed, you'll need to make a larger monthly
payment.
LTV (Loan-to-Value)
This percentage is computed
as follows: Loan Amount/Appraised Value of the Home. As
an example, a loan of $80,000 on a home valued at $100,000
has an "LTV" ratio of 80%. In the case of a home
equity line of credit, the LTV is the total loans, including
the line of credit, as a percentage of the value of your
home.
Mortgage Insurance
Mortgage insurance insures
the lender he will be protected from loss should you cease
making payments. Very often, you will not be required to
pay mortgage insurance if your down payment is more than
20% of the appraised value of your home. Check with your
lender to see how your mortgage insurance can be waived.
Origination Fees
This fee is usually 1% of
the loan amount and pays the lender for processing and originating
your loan. As an example, the origination fee on a $100,000
mortgage loan is $1,000.
Prepaid Interest
This is the amount of interest
you owe from the day your loan funds to the end of the month.
Here's an example:
If you close on the 15th
of January and your interest is $21 per day, you would pay
16 days x $21=$336 for interest for the month of January.
Your first payment would be due on March 1st and would pay
principal and interest for the month of February
Property Taxes
The amount you pay varies
significantly from area to area and is usually a set percent
of your property's value. If you need help estimating your
yearly property taxes, please contact your county assessor's
office.
Savings Rate
Savings rate refers to the
annual amount of interest you can earn on money you save.
For many people, a savings account which earns 3.5% to 4.5%
interest is an appropriate choice.
This rate is generally used
to compare two loan options. For example, if you decide
to make a larger down payment on your home, you are sacrificing
the interest you would have earned on the additional amount
of money. The calculators take this "time value of
money" into account.
Tax Rates
In some home financing calculators,
you are asked to make a comparison between two financing
options. If one of the options costs more than another,
the difference is invested into a savings account because
you've saved money with that option. To make a fair comparison,
the calculator tracks the balance and interest earnings
on this account. As earnings in this account grow, they
are taxed at the rate you indicated.
Your personal tax rate is
also used to compute your tax savings.
To estimate your tax rate, divide the amount you paid in
taxes last year by your income.
Tax Savings
If you itemize your tax return,
you will probably be able to claim a deduction for the interest
you have paid on your mortgage loans, including home equity
lines of credit. A deduction is the amount you are allowed
to subtract from your taxable income. It reduces the amount
of your income on which you must pay taxes.
When you report your income
to the IRS, you are allowed to reduce the amount of income
which will be taxed by either
1. A predetermined amount
("Standard Deduction") or
2. An itemized list of specific types of expenses you incurred
("Itemized Deductions") Standard Deductions vary
according to your marital status.
Term
The length of time that you
will make payments on your loan. Typical mortgages have
terms of 15, 30 or 40 years.
