Posts Tagged ‘arm’
The primary disadvantage of the ARM loan is obviously the adjusting interest rate. The caps provide some degree of protection; however, any rate and payment adjustment still hurts.
Also, if the ARM starts with a teaser rate, then the new adjusted rate is bound to be higher—even if the market rate does not increase. Many borrowers will look at the first periods of the ARM—when the teaser discount is still in effect—to be the ARM loan’s honeymoon. Eventually, however, reality must beckon.
A second, albeit minor, disadvantage of the ARM loan is that the mortgage insurance, if any, will be slightly higher than the fixed-rate loan. The mortgage insurance premiums for ARM loans will normally be 10%-20% higher than the mortgage insurance for comparable fixed-rate programs. The reason for this is because ARM loans do tend to carry more risk for the borrower. Remember that ARM loans allow the borrower to share more of the loan’s risk with the lender. The mortgage insurance is merely a reflection of that increased borrower risk, which is borne out by higher default levels of ARM loans. Nevertheless, ARM programs have their moments. The key for the home buyer is to use short-term ARM loans for short-term purposes.
The interest rates charged by ARM loans tend to start at a lower level than similar fixed-rate loans. With conforming programs, ARM loan rates tend to start 1.500 to 2.000 percentage points lower than comparable fixed-rate loans. Non-conforming ARM rates tend to be 2.00 to 5.00 percentage points lower than comparable non-conforming fixed-rate programs.
Although ARM loans start with a lower rate and payment, the applicant must be qualified and underwritten using a rate that is higher than the start rate. Most lender will qualify the applicant’s income based on a monthly payment with an interest rate of two (2) percentage points greater than the start rate. For example, if the ARM loan’s start rate is 5.750%, the lender will normally qualify the applicant at a 7.750% interest rate.
Some conforming lenders and many non-conforming lenders will offer a slight advantage to the borrower by qualifying based on the fully indexed rate. The indexed rate is the program’s margin added to the current index rate. Essentially, the fully indexed rate offers no teaser discount.
An additional protection for most ARM and balloon loan borrowers is the option to convert into a long-term fixed-rate loan. The conversion option is not a refinance, although it looks and acts like one. Rather, the conversion option amends the original mortgage loan note, without substantially changing the mortgage and title record. For example, an ARM loan borrower who is in the third year of her loan can convert it into a 27-year fixed-rate loan. The interest rate of the new fixed-rate loan will be based on current market rates, as predefined in the conversion option clause Most lenders charge a fee of $200 to $500 to prepare, execute and record the conversion documents.
Borrowers must also meet certain requirements to exercise the conversion option. They cannot be delinquent on the account or have an unacceptable payment history. In addition, there will be a time limit to the option. With most loans, borrowers must exercise the conversion option after the first full year and before the end of the fifth year.
The most important advantage of ARM loans over fixed-rate programs is the ARM loans’ low initial start rates. These are often called teaser rates, because they are meant to attract borrowers to these slightly riskier program.
The ARM loan’s start rates are typically 1.5 to 3.0 percentage points lower than comparable 30-year fixed-rate programs. In some rare occasions, the spread could be even more pronounced. The graph of the difference between the rates of short-term and long-term loans is often called the yield curve.
There have been a few brief periods when fixed-rate loans offered the nearly the same interest rates as ARM loans. This occured because the fear of long-term inflation, which controls longterm loan rates, was minimal; while the fear of short-term inflation, which affects short-term loan rates, was high. Such periods produce what is often called an inverted yield curve.
Some ARM loans run the risk of negative amortization, in which the loan’s principal balance is increasing rather than decreasing. Negative amortization occurs whenever the monthly payments are not enough to cover the interest due on the debt. Unless the loan explicitly waives this unpaid interest, that deficit amount is added to the principal balance. This unfavorable situation is a regular byproduct of ARM loans with payment caps. Often, the payment caps so limit the payment adjustment that the new payment calculation is not enough to cover the interest due on the loan. Worse yet, as unpaid interest is added to the principal balance, the borrower will be charged interest on the unpaid interest. Because this situation could lead to endlessly increasing principal balances, ARM loans with payment caps usually also contain principal caps, as a protection against negative amortization. Principal caps still allow negative amortization to increase the principal balance, but sets limits on how high the principal may increase. Most principal caps limit negative amortization increases to 125% of the original loan balance. Thus, an ARM loan with negative amortization and an original balance of $100,000, can have its principal increase to $125,000.
Any unpaid interest after that limit is reached is usually waived by the lender. It would seem apparent that negative amortization is undesirable. But ARM loans with payment caps and negative amortization are still prevalent, because they usually offer very low start rates. For borrowers who intend to keep a loan for only a year or so–even though the loan is amortized for 30 years–these loans could be wise investments.
The period is the span of time that a lender must wait before it can readjust the interest rate of the ARM loan. The lender may only change the interest rate on a loan once each period, normally on the anniversary date of each period. The exception are ARM loans based on the prime rate, which normally have no set period. This is the case with many credit cards, business loans and commercial loans. The prime rate is adjusted by banks, according to overall market conditions. The prime rate may not change for two years in a row; then it may increase five times in one month. Typical periods can range from one month to several years, with one-year ARM periods being the most common.
Generally speaking, ARMs with shorter periods usually provide lower interest rates, since shorter periods give the lender more opportunities to adjust the interest rate—and thus further lower the lender’s overall risk exposure.
Do not confuse the loan term or amortization with the period. A 30-year amortization is the norm for all ARM loans, although shorter amortization settings and terms are also available. Note that similar to the conventional fixed-rate loan, the ARM loan’s term and amortization are the same.
For example, a 3/1 ARM is basically a one-year ARM loan with one-year periods. However, for the first three years, the ARM loan’s rate is fixed (will NOT adjust). After the third year, the ARM loan’s rate will begin adjusting as normal. The 2-year/6-month ARM is primarily used by non-conforming loan programs.
Most residential loans in the past have been fixed-rate loans with short terms. Before the Great Depression of 1920s and 30s, many of these loans were balloon programs, often with high rates. This was necessary because the mechanism that ARM loan adjustments depend on, a reliable index, had not been widely available. The residential ARM loan was first introduced into the national market as the Variable Rate loan. This term still remains in use with credit cards and installment loans, but it has been replaced in the mortgage industry with the more specific and catchy “ARM” description.
When the variable rate mortgage loan first appeared, it was overly restrictive on the lender. So much so that many of them lost money on it. That was good news for borrowers in the short term; but it was bad news in the long term, as lenders and investors threatened to abandon these programs. In the past three decades, the variable rate mortgage was renamed and further redeveloped, as well as diversified, into today’s ARM loan. Most home buyers still have a natural aversion to ARM loans. Older homeowners who remember the 19% interest rate of the 1970s, are especially leary of the inherent risks of ARM programs. However, ARM loans do have their advantages, which make them ideal for people who can see the home or property purchase as a financial investment.
First of all, if you are only keeping the home for three years or less, you will save money by selecting an ARM loan, instead of a fixed-rate loan. Even if you decide to stay past the third year, many ARMs have a conversion option and some lenders provide no-lender-cost refinances. With the development of 3/1, 5/1 and 7/1 ARMs, which will be discussed in more detail below, ARM programs ffer an even greater opportunity for homebuyers planning on up to a seven-year ownership period with any one property.
When compared side-by-side, the typical borrower will still save more money with the 1-Year ARM (compared with the fixed-rate) for the first three years. After the third year, depending on how the market reacts, the fixedrate or balloon loans are generally better. The reason for the ARM loan’s advantage is that even with any wild increases in the market’s current interest rates, the rate increase caps—or limits—means that monthly payments normally remain lower with the ARM loan for at least two years.
Secondly, ARM loans are the program of choice during periods of high interest rates. History has shown that interest rate fluctuations are normal and tend to be cyclical. During times of comparatively higher rates, borrowers can elect to go with an ARM loan that has a much lower interest rate than theregular 30-year fixedrate. When the market finally improves to lower rates, the borrower can refinance his or her loan. Even if you plan to keep your newly found property forever, if you find yourself searching for a mortgage loan during a period of relatively higher interest rates, go with the lower teaser rate of the ARM loan. Then, once interest rates have decreased, just refinance the mortgage loan to a lower rate—preferably a fixed-rate program. Many times, your current lender will give you a free refinance, just so they can keep you as a borrower.