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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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 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.
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 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.
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.
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
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 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.
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.
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.
The length of time that you will make payments on your loan. Typical mortgages have terms of 15, 30 or 40 years.