How can I best understand adjustable rate mortgages?

The best way to understand an adjustable rate mortgage is to look at a specific example and then, using made-up numbers, examine some variations.

Example: The terms of the loan are as follows. It has a start rate of 2% interest. After six months, the rate changes to 5%. The 5% rate is the rate of the Federal Reserve 11th District Cost of Funds (the index for this example) of 3% plus a 2% margin. The cap is 5%, so you can never pay more than 10% interest. Some lenders will say that the cap is 10% when explaining this loan. Always ask if they define the cap as the total interest that can be required or the amount of the increase. The adjustment period is six months. The adjustment cap is 1%.

Every six months, you must look at the current rate of the index. The interest rate rises or falls by the same amount as the rise or fall of the index rate, up to the cap of 1% per six-month period. This is where the first problem arises. If the interest rate goes up, does your monthly payment also go up? The answer is a definite maybe. Depending on the terms of your specific loan, you may have an increase in your monthly payment that fully reflects the increased interest, partially reflects the increased interest, or does not change at all.

If you owe $300,000, a 1% rise in interest is $3,000 per year. That is $250 per month. This may strain your budget. If your payment increases by less than $250, you are not paying down your loan as quickly as you might have anticipated. If your payment does not increase at all, you could quickly be paying interest only or less (negative amortization). You can voluntarily increase your monthly payments to avoid this, but can you really afford it?

You can easily see that timing is critical for an adjustable loan. If interest rates are at historic highs when you get your loan, your rate will probably adjust downward. An added bonus is that falling interest rates usually cause an increase in property values.

If you use an adjustable loan when rates are at historic lows, you will probably see your rate go up. One problem is that rising interest rates usually cause property values to stabilize or fall. In an extreme case, you would no longer be able to afford to make your increased monthly payment, and falling property prices would make you unable to sell.

The logical question is, "Why would anyone want an adjustable loan when interest rates are low?" The major reason is that it is the only way for them to qualify for a loan. The formula used to qualify a buyer for a loan considers the beginning monthly payment, not the possible future monthly payments. It is similar to the interest- only loan situation with the balloon payment. If it is the only way to home ownership, you take the risk.

A more sound reason would be that your job requires you to move every few years. You will pay lower interest and fees for the adjustable loan and you will probably sell before the rates change too much.

What is a flexible payment adjustable rate mortgage?

A lender may suggest a flexible payment adjustable rate mortgage, which limits the payment increase in order to ease the borrower's fears. The flexible payment aspect of the loan looks like a solution to the problem. The typical loan of this type will call for a payment adjustment of no more than 7.5% per year, based on the start rate payment. However, there are two problems with this loan for the borrower.

First, the increased payment will usually not be enough to cover interest only (negative amortization). This is especially true in a market in which the index rate is rising. Remember, the margin is part of the interest rate. A high margin will cause negative amortization even if the index rate is stable or falls slightly.

In flexible payment adjustable rate mortgages, there is a clause that states that if the negative amortization reaches a certain level — usually no more than 125% of the original loan amount — the payment will be adjusted to amortize the loan, superseding the payment cap. Since you owe more than you originally borrowed and have less time to pay it off, the payment will be even higher than if you originally agreed to fully amortize the loan over the original loan term.

What is recasting and how will it affect my mortgage?

The second problem is that the loan will be recast periodically, commonly every five years. Recasting means that the payment is adjusted to fully amortize the loan in the remaining time of the term. This recasting clause also supersedes the yearly payment cap and adjusts the payment to whatever is necessary to pay off the loan in the remaining term. What is the answer? It is the same old story of common sense. If the start rate and initial monthly payment are far below prevailing rates and the payment amount necessary to amortize the loan amount in the agreed-upon term, be careful. You know how much you are borrowing. You know the real interest rate that you will have to pay (the index plus the margin). You know how many years you have to pay it off (the term).

What does common sense tell you? The less you pay in the early years of the loan, the more you will have to pay later.

It also tells you that the smaller the payment, the less will go to principal. This means that you will pay much more interest than in the price of the early smaller payments. Studies done on these loans show increases in the monthly payment well over 100%, even if the index rises only slightly. The higher the margin and the lower the start rate, the greater the payment increase. It has been suggested that lenders should be required to raise the start rate based on their margins. A lender with a 4% margin would be required to have a higher start rate compared to a lender with a 2% margin. This would narrow the gap between the initial required payment and the adjusted payment if maximum negative amortization occurs, or when the loan is recast. However, there is currently no law or regulation requiring lenders to do this. Again, the time element is very important. If your income does not allow for a standard payment, interest rates are high and are expected to fall, housing prices are on the rise, and you plan to sell the home within five years, this may be a great loan. Unfortunately, most of these ifs are unpredictable.

The smarter way is to work out a somewhat pessimistic scenario of the possibilities. If you believe you can survive the worst case and the only loan that will allow you to buy the house is one with a low start rate and high margin, you are at least making an informed decision.

From the Expert

It is not difficult to avoid payment shock. Some simple figuring on your own will tell you what to expect. As a result, you will be less likely to get caught in the trap of deciding if this type of loan is good for you.

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