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Message # 925 Adjustable rate mortgages

mp3 #925 Adjustable Rate Mortgages (mp3 file)

If you are in the housing market, or plan to be there anytime soon, chances are good that the loan you take out to pay for the house might be some kind of adjustable-rate mortgage, called "ARMs". Recent deregulation of mortgage instruments has given rise to what one regulator calls an "alphabet soup" of adjustable-rate mortgage loans. Surveys have turned up more than 50 different types in California alone. Arms have created some confusion and uncertainty for both lenders and borrowers.

Properly structured, ARMs can be an acceptable form of home financing. They have helped shelter prospective homebuyers from the full brunt of upturns in interest and made it possible for more people to realize the dream of buying a home. But ARMs can also make that dream a nightmare for borrowers who don't know what they are getting into. Most borrowers are attracted by the apparent benefit of ARMs without fully understanding how the adjustable rate mortgage will react to future changes in the financial market.

For many new homebuyers, an ARM may be the only type of mortgage for which they qualify. Whatever your financial status, however, if you are in the mortgage market, you probably need to know something about ARMs.

ARMs were introduced into the mortgage market as a way for lenders to reduce the risk that interest rates would change significantly over the long term. When interest rates have skyrocketed in the past, banks and savings and loans institutions were stuck with low returns on older outstanding loans and higher interest rates to pay out on deposits. As a result, they became reluctant to make long-term commitments in the mortgage market.

An Adjustable Rate Mortgage has a rate of interest that changes with the market interest rate. There is no one type of ARM and later in this message some different features of ARMs are explained. The ARM is different from the traditional mortgage because a traditional mortgage normally has a fixed rate of interest and a fixed monthly payment, unlike an ARM where both can change.

The introduction of the adjustable rate loan meant that significantly greater amounts of cash could be made available to prospective borrowers. Lenders were no longer unwilling to make long-term commitments, because they could pass on to borrowers some of the interest rate risk. In return, borrowers would get lower initial rates on ARMs than on fixed rate mortgages.

Some lenders offer introductory "teaser" rates on their ARMs that are as much as 4 to 6 percent below market rates. While borrowers may qualify initially for such discount loans, many won't be able to handle the payments when the cost of their mortgages shoots up. For example, an increase of three percentage points in a homeowner's annual mortgage rate could mean a 22 percent increase in his monthly payments. The risk of default on ARMs is greater than on other mortgages. In effect, banks are in danger of exchanging interest rate risks for credit risks, and borrowers are in danger of taking out loans they cannot really afford.

Despite the drawbacks, however, most representatives of the mortgage industry agree that ARMs are here to stay.

Some experts advise prospective homebuyers to comparison shop ARMs, if that is their best (or only) mortgage alternative. But that may be easier said than done. It has become very complicated to shop and compare ARMs, because you're comparing apples with oranges with pears with grapes. There are many different kinds of ARMs available.

Some recommend having a realtor do the first screening of ARMs. Some recommend that homebuyers work with a tax accountant or attorney before committing themselves to an ARM. But even then, the problem is that ARMs change every week.

The following are some of the basic components of adjustable rate mortgages. These are a few of the factors to look at when you consider taking out an arm:

1. The lender -- ARMs are available from a variety of lenders. Most mortgages, including adjustable ones, are still made by savings institutions. Other major sources of mortgage loans are full-service banks, and mortgage bankers, who specialize in making mortgages. Since each type of lending institution is regulated by a different federal agency, has a different financial structure, and sells its mortgage loans to different kinds of investors, the loans differ as well. One fact you should know is that loan officers or agents at some lenders work on a commission basis, while others are salaried and get paid whether or not they sell you a loan.

2. Organization fee -- lenders charge a fee for processing the loan, ranging from .5 percent of the total amount of the loan to 2 percent or more.

3. Loan amount -- most lenders will not lend more than 80 percent of the total value of the real estate, without requiring the buyer to buy mortgage insurance from a private insurer. Many loans, offered by lenders who resell their mortgages on the secondary market, have ceilings, even though studies show that the average mortgage loan in California is often higher than the ceiling amounts. Monthly payments must usually total no more than 28 percent of the borrower's gross income.

4. Index -- ARM rates are tied to the movements of a specific index. If the index goes up, the interest rate on the ARM goes up. If it goes down, the rate goes down. Lenders are free to use any of several indices, as long as they are public information, are not under the lender's control, and are easily verifiable and understood by the borrower. Lenders commonly use one or more of three types of indexes: an index based on mortgage rates, such as the Federal Home Loan Bank's Monthly Mortgage Rate Series; an index based on the bank's cost of funds; or an index based on the return on treasury securities of varying maturities.

5. Margin -- also known as the "spread," the margin remains the same throughout the life of the loan, but it is not set until you actually sign the promissory note. The margin indicates how much above the index amount the bank will charge you in interest. A 2 percent margin means that you will be paying the interest rate indicated by your index, plus an additional 2 percent, every time you make a payment. Margins vary according to the lending institution and the index used, as well as according to various loan features such as limits on the amount payments can raise in a particular period, or the amount of interest chargeable over the life of the loan.

6. Initial interest rate -- most lenders offer a discount initial interest rate on their ARMs. For example, if a lender's ARM index stands at 10 percent, and his spread is 3 percent, the interest rate for the ARM he offers should equal 13 percent. But he may offer an initial rate of 11 percent for the first six months, and later add on the difference to the amount and rate you are paying. The difference can be added on all at once or gradually. Thus, your payments can increase, even if the interest rate index stays the same, or if it declines less than the difference between the "real" rate and the rate paid initially. Or the difference between the rate you are initially being charged, and the rate at which you are paying, can be added to the principal.

7. Adjustments -- at periodic intervals, the interest you are paying on your ARM, and the amount of your monthly payment will be adjusted by the lender to reflect changes in the index. Common adjustment periods are every six months, every year, every three years, or every five years. However, the frequency of interest rate adjustment and the frequency of payment adjustment will not necessarily be the same. For example, the interest rate on your loan could be adjusted every month, while the amount of your monthly payments could be adjusted every year. These one-year adjustments, needless to say, could be substantial if interest rates change significantly.

Some plans adjust the term of your loan, rather than the monthly payments. Under these fixed-payment plans, lenders simply extend or shorten the number of months required to pay off your loan, based on the movements of the index. Your monthly payment amount would then always remain the same.

Some ARMs are adjusted in such a manner that a "negative" will result. This means that you have not been paid enough to pay off the amount of interest due. The unpaid interest will then be added to the principal amount. Some lenders will send you a payment statement that gives the option of paying off all of the interest due and fully amortizing the loan. You may want to make sure you are paying off all the interest due so that you don't wind up paying interest on the unpaid interest.

8. Caps -- many plans have limits or caps on the amount your payment or interest rate can change over a given period. One plan, for example, which adjusts both interest rates and monthly payments once every six months, limits the possible change in interest rate charged for each adjustment period to 3/8 of 1 percent. Another plan limits the possible change in amount of monthly payment per one-year adjustment period to 7.5 percent. If interest rates rise 1 percent during a one-year period and that would mean a 10 percent increase in your monthly payments, the increase will be limited to 7.5 percent under this plan.

These caps may be deceptive, however, since under some plans, increases that exceed these limits may be carried over into the next adjustment period. In such a case, even if your index goes down in one period, the rate and amount you pay may go up. Or, there may be periodic "recasts" every five years or so, when your loan will be "recast" to take into account changes in interest rates without regard to yearly or monthly caps. Under some other plans, interest that exceeds the amount of monthly payments may be added to the principal and cause "negative amortization" -- the amount you are paying interest on actually goes up. You are paying interest on interest, and you can end up owing more than you borrowed. Some plans have caps on possible negative amortization, ranging from 105 percent to 125 percent.

Still another kind of cap, featured in many plans, limits the total amount that interest rates can change over the life of the loan. Such caps usually range from about 3.5 percent to 10 percent.

More information on ARMs can be obtained from lenders, the Federal Home Loan Bank, or the California Association Of Realtors, 525 South Virgil Avenue, Los Angeles 90020.

The information in this SmartLaw message originally appeared as part of an article in the California Lawyer magazine and was written by Art Garcia, a Senior Editor of California Business Magazine.

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