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Adjustable-Rate Mortgages

Adjustable-rate mortgages (ARMs) are most popular w hen interest rates are high and the interest rate on ARMs is much lower than the interest rate on fixed-rate loans. Usually, fixed-rate loans are the loan of choice. ARMs are good to consider w hen:

• You believe that rates are going to fall to levels much lower than they are today.

• You plan to keep your home for only two or three years, and an ARM looks less expensive in the short term.

If you have an ARM right now and are wondering whether to refinance to a fixed-rate mortgage, this section, as well as Chapter 8, can help you decide what to do.

The obvious difference between an adjustable-rate mortgage and a traditional fixed-rate mortgage is that with an ARM, the interest rate goes up and down (see Figure 4.12). It changes according to a set formula every year or so for the life of the loan. Usually, your monthly payment goes up and down with the interest rate.

Basic and Optional Features

An ARM, much like an automobile, has some basic features and a number of options. This section covers the four basic features common to all ARMs and the four most common optional features.

Basic Features

• Index

• Margin

• Adjustment interval

• Initial interest rate

FIGURE 4.12 Fluctuating Interest Rates with Adjustable-Rate Mortgages

Fluctuating Interest Rates with Adjustable-Rate Mortgages

Optional Features

• Life interest rate cap

• Periodic interest rate cap

• Monthly payment cap

• Convertibility to fixed-rate

• Interest-only period (see previous Adjustable-Rate Mortgage section)

Basic features. Features of ARMs include the margin, index, adjustment interval, and initial interest rate.

Index. An ARM's interest rate goes up and down according to a nationally published index (see Figure 4.13). Your lender has no control over the index and cannot arbitrarily adjust your rate. Your rate is determined by the index.

FIGURE 4.13 How Index Affects Interest Rates of Adjustable-Rate Mortgages

How Index Affects Interest Rates of Adjustable-Rate Mortgages

Different ARMs follow different indexes. The One-Year Treasury Bond Index is the most common ARM index. Other indexes are:

• 11th District Cost of Funds Index (COFI)

• Certificate of deposit index (six-month index)

• Federal Home Loan Bank Board (FHLBB) Contract Rate Index

• London Interbank Offering Rate (LIBOR) Index

The Cost of Funds index is better for consumers than the Treasury Bond and FHLBB indexes because it does not go up as quickly when overall interest rates rise. From 1993 to 1994, the One-Year Treasury Index rose from 3.4 percent to 7.1 percent while the COFI rose from 3.9 percent to only 4.6 percent. The business or real estate section of your newspaper frequently reports the current values of the most commonly used mortgage indexes.

FIGURE 4.14 Relation of Margin to Adjustable-Rate Mortgages

Relation of Margin to Adjustable-Rate Mortgages

Margin. Your ARM's interest rate is the sum of the index value plus the margin. Your lender sets the ARM's margin before settlement of your loan. Once set, the margin does not change for the life of the loan. In the hypothetical example in Figure 4.14, the margin is 2.75 percent. At the end of year 5, the index is 7.75 percent. So the rate for year 6 becomes 10.5 percent (7.75 percent plus 2.75 percent). Warning: ARM margins vary from lender to lender. If you have two identical ARM loans, one with a 2.5-percent margin and one with a 3-percent margin, the loan with the lower margin is better.

Adjustment interval. The interest rate of an ARM changes at fixed intervals. This is called the adjustment interval. Different ARMs have different adjustment intervals. The interest rate of most ARMs adjusts once a year, but others adjust every month, every six months, every three years, or every five years. An ARM whose rate changes once a year is called a one-year ARM; the example in Figure 4.15 is a one-year ARM. Sometimes the first adjustment interval is longer or shorter than following intervals. For instance, an ARM's interest rate might not change for the first three years, but then change once a year thereafter. Alternatively, the initial rate might

FIGURE 4.15 How the Adjustment Interval Works in Adjustable-Rate Mortgages

How the Adjustment Interval Works in Adjustable-Rate Mortgages

change alter 14 months rather than a year, to accommodate the lender's accounting systems.

Initial interest rate. The final feature common to all adjustable-rate mortgages is the initial interest rate. This is the rate that you pay until the end of the first adjustment interval. The initial interest rate also determines the size of your starting monthly payment, which the lender usually uses to qualify you for the loan. Note that for loans with exceptionally low initial interest rates, the lender may qualify7 you at a higher rate, usually the fully indexed rate, or the second-year maximum rate. The initial interest rate in Figure 4.16 is 5 percent.

Often the initial interest rate is lower than the sum of the current index value plus margin. When it is several percentage points lower, it is called a teaser rate. If your ARM starts with a teaser rate, your interest rate and monthly payment will increase at the end of the first adjustment interval unless your ARM's index goes down enough to offset the discounted teaser rate.

FIGURE 4.16 How the Initial Interest Rate Works in Adjustable-Rate Mortgages

How the Initial Interest Rate Works in Adjustable-Rate Mortgages

Optional features. Most ARMs have consumer protection options that limit the amount that your interest rate and monthly payment can increase. They are called caps.

Life interest rate cap. The life interest rate cap sets the maximum and minimum interest rates that you can be charged for the life of the loan. In the example in Figure 4.17, the life interest rate cap is 10 percent. In year 6, the index value plus margin equals 10.5 percent, but the life cap limits the rate increase to 10 percent. Even if the index went to 16 percent, as it has in the past, the interest rate of this ARM would still be limited to 10 percent.

Sometimes the life cap is quoted in percentage points over the initial interest rate. For example, a “5-percent life interest rate cap” means 5 percent over the initial rate, which in Figure 4.17 is 5 percent.

Periodic interest rate cap. The second type of cap is the periodic interest rate cap. It limits the amount an ARM's interest rate can change from one adjustment interval to the next. In the example in Figure 4.18, the periodic interest rate cap is 2 percent. This means that the ARM's interest rate cannot go up or down more than 2 per-

FIGURE 4.17 How the Life Interest Rate Cap Works in Adjustable-Rate Mortgages

How the Life Interest Rate Cap Works in Adjustable-Rate Mortgages

cent from one year to the next, even if the index goes up or down more than 2 percent. In the example in Figure 4.13, the index went up 2.5 percent from year 4 to year 5. Without a periodic interest rate cap, the ARM's rate would have gone from 7 percent in year 4 to 9.5 percent in year 5. With a 2 percent periodic rate cap, however, it goes to 9 percent.

An adjustable-rate mortgage like the one in Figure 4.18 is called a “one-year ARM with two and five caps."

Monthly payment cap. The third type of cap is the monthly payment cap. It limits the amount that your monthly payment can increase from one adjustment interval to the next. Figure 4.18 shows the effect of a 7.5 percent monthly payment cap. Without the cap, the monthly payment would have gone up $250 from $1,074 to $ 1,324. With the cap, it went up only $80 to $1,154 (see Figure 4.19). ARMs with payment caps may, like GPMs, incur negative amortization, but if the ARM also has a life interest rate cap, the negative amortization is minimal.

FIGURE 4.18 How the Periodic Interest Rate Cap Works in Adjustable-Rate Mortgages

How the Periodic Interest Rate Cap Works in Adjustable-Rate Mortgages

ARMs usually have a monthly payment cap or a periodic interest rate cap, but not both. Either of these caps provides you with good protection against extreme increases in your monthly payment. The monthly payment cap provides slightly better protection

FIGURE 4.19 How You Can Benefit from a Monthly Payment Cap in Adjustable-Rate Mortgages

How You Can Benefit from a Monthly Payment Cap in Adjustable-Rate Mortgages

FIGURE 4.20 Convertibility to Fixed-Rate in Adjustable-Rate Mortgages

Convertibility to Fixed-Rate in Adjustable-Rate Mortgages

than the periodic interest rate cap, but through negative amortization, you pay for the better protection with more interest charges.

Some of the ARMs offered in the past and some of the adjustable-rate second mortgages offered today have no caps. If a lender offers you an ARM with no caps, beware! If you plan to pay it off in a year or two, it probably will be no problem for you, but if you are looking for a long-term loan, get a fixed-rate mortgage or an ARM with caps.

Convertibility to fixed rate. The fourth optional feature, which can be a great benefit to consumers, is convertibility to fixed rate (see Figure 4.20). ARMs with this feature can be converted at the borrower's option to a fixed-rate mortgage without refinancing.

The terms of convertibility vary substantially from lender to lender. Some ARMS with this feature are convertible at any time, others only during the first five years, and still others only at the end of live years. The fixed-rate loan to which you can convert may not be a “market” rate at that time. Most lenders add a margin to the existing fixed rates for purposes of conversion, making a converted fixed rate somewhat higher than market rates. The lender's disclosures and the ARM note specify the terms of conversion.

Lenders often charge a one-point fee for the convertibility feature, either at the inception of the loan, at the time of conversion, or at both. A good conversion feature is worth the additional fee. Most people who choose an ARM when rates are high prefer a fixed-rate mortgage. With a convertible ARM, they can wait until rates fall and convert to the fixed-rate loan that they really wanted in the first place.

 
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