June 3rd, 2018 7:39 AM by Jackie A. Graves, President
Question: We are first time homebuyers, and have
just signed a contract to purchase a new home in Virginia. Interest rates appear
to be reasonable, and the builder has given us a sizable credit to be used for
closing costs. The builder has recommended we use a particular lender, and has
strongly suggested we get an adjustable rate mortgage (ARM). We are interested
in this kind of mortgage, but do not really understand how it works. What
exactly is an ARM, and is this something we should consider?
Answer: Mortgage lenders are creative. When interest rates skyrocketed
in the early l980's, the mortgage financing industry began developing new and
imaginative loans to meet everyone's needs. Many of these mortgages have
acronyms, and over the years there were such mortgages as GEMS (Growing Equity
Mortgages), RAMS (Reverse Annuity Mortgages), SAMS (Shared Appreciation
Mortgages) and of course ARMS (Adjustable Rate Mortgages).
us look carefully at the adjustable rate mortgage.
was created in the early 1980's when lenders were affected financially because
homeowners were repaying their mortgage loans at 8%, 9% or 10%, while the cost
of borrowing that money was more than 15%.
made a basic economic decision many years ago. The shorter the term of the
loan, the lower the interest rate would be. Thus, today you can still obtain a
fixed rate, 30-year mortgage, meaning that your monthly payment (principal and
interest) is guaranteed to be the same each and every month. But the fixed
rate, 30-year mortgage, although reasonably low today, still carries about the
highest interest rate going.
adjustable rate mortgages are guaranteed to stay on the books for 30 years, but
the interest rate is adjusted periodically. There are many variations on this
adjustable rate theme. There is a 7-23, where the rate is fixed for the first 7
years, and then adjusts annually thereafter for 23 more years. If the rate is
adjusted for 5 or 7 years, the initial rate will be lower than for a 30-year
fixed rate mortgage, but higher than an adjustable rate mortgage that is
adjusted every year.
the most common ARMS are the 1 year, or the 5 year. But even with these common
ARMS, prospective home buyers must shop around for the best deal. Consumers
must also carefully inquire as to all of the terms and conditions before they
commit themselves to any kind of mortgage financing. And in addition to asking
questions, you should insist on getting a written statement from the
prospective lender reflecting all that you have been told-- and promised.
is what you should do:
the initial interest rate. It is defined as the rate on which your loan will be
based during the initial period - - whether it is 1, 3, 7 or 10 years.
out how many points the lender is charging. Each point equals one percent of
the loan. Thus, if you are obtaining a 1 year adjustable rate at 6.5 percent,
and the lender is going to be charging you 2-1/4 points, a loan of $150,000.00
will require you to pay $3,375.00 in points -- up front -- when you settle on
your house. Points are not as common in today's marketplace, but some lenders
are still requiring that points be paid. And if you want to reduce the interest
even lower, you can volunteer to pay a point or two; but please do your
homework and your math. You don't want to be throwing good money after bad. A
good ballpark is that each point will reduce your rate by one-eighth of a
percent. The ideal solution is to convince your seller to pay a point or two;
you reduce your interest rate, and can deduct those seller-paid points on your
income tax return.
if the ARM is based on a negative amortization schedule. Although my experience
is that most ARMS currently are not amortized on such a negative basis, I still
have seen some loans with a negative factor built in. This means that although
you may be paying a lower interest rate, perhaps 3 1/2 or 4% for the first few
years, the interest still is being charged on your loan at a higher rate -- for
example 5 or even 7percent. If this is the case, the extra interest, which is
the difference between what you are paying and what is being charged you, is
added to your mortgage balance. I cannot recommend the negative amortization
mortgage under any circumstances.
what the rate adjustment will be. Find out if there is a cap on the periodic
increases and determine what index the lender uses as a base for calculating
changes in the adjustable rate.
lenders look at the Federal Funds Rate, which is published by the Federal
Reserve Board. Some lenders use an index known as LIBOR (London Interbank
Offered Rate) while others may use such rates as (1) the current prime rate,
(2) 10 year Treasury, or even Fannie Mae 30/60 . Ask your lender to provide
youwith historical data comparing these various indices. Alternatively, you can
find this information on the internet.
lender then adds to that index number a rate adjustment, called a margin. If
the adjusted rate is higher than the old one when your adjustment period comes
due, your interest will be modified accordingly for the next set of payments.
example, the current Treasury bill index for one year is 2.25%. The rate
adjustment offered by the lender (the margin) is 3 points. Even if the Treasury
bill index stays at the same next year, if you have a 1 year ARM, and your
current rate is 3.25%, your new payment for the next year could be increased to
6.25% (3.25 plus 3).
if there is an annual rate cap, all yearly adjustments on your mortgage
payments cannot exceed that cap. Thus, even if the index increases
substantially, your new interest rate can only rise the first year not to
exceed the cap. Clearly, you should insist on having your loan documents
include a yearly cap.
point to consider is whether there is a ceiling on the overall amount that your
rate can increase. Lenders realize that an ARM without such a ceiling is a
potential disaster for consumers -- and potentially bankruptcy and foreclosure
for lenders. If you start with a 3.25% loan, for example, and there is a 2%
point cap in the annual increases, it is conceivable that at the end of the 5th
year, you would be facing a mortgage rate of 13.25%.
lenders, therefore, impose an overall ceiling on the amount that your interest
rate can rise. However, make sure you fully understand what these ceilings are,
and get them in writing before you commit yourself to an ARM or to a particular
should also make sure that your loan is, in fact, based on a 30-year
amortization schedule. You also want written assurances that so long as you are
current in your monthly mortgage payments, your loan will continue for a
30-year period. Some lenders have created adjustable rate mortgages that
balloon at the end of a particular period of time -- for example, ten years.
This means that while the lender will probably renew your loan, it reserves
right to call it due at the end of the 10th year, depending on many
circumstances, all of which must be outlined in writing to you before you
commit yourself to that particular kind of loan.
are also serious problems with interpreting how the rate adjustments work after
you get the loan. Anyone with an ARM is advised to carefully review their
original loan documents, to determine whether the lender has properly and
correctly assessed the new adjustable rate, when the adjustment period comes
have been a number of economic analysis studies throughout the United States,
which have concluded that lenders have made a number of mistakes. Ironically,
not all of the mistakes were in the lender's favor.
also indicated that your seller was recommending a lender. Make sure you shop
around before you commit yourself to any loan.
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