It
is popular with the lenders because the ARM shifts the risk of interest
rate fluctuations to the borrower.
Although
borrowers would rather have the security of a fixedrate loan provided
the rate is not too high, the ARM has maintained its popularity in the
market despite competitively priced mortgage loan rates.
An
ARM is a loan that allows the lender to adjust the interest rate so it
reflects fluctuations in the cost of money more accurately. However,
with an ARM, the borrower is the one who is affected by interest rate
movements, not the lender. If interest rates rise, the borrowers
payments also go up  if the rates fall, the borrowers monthly payments
will drop along with the declining rates.
HOW
AN ARM WORKS
The
borrower's interest rate is determined by the cost of money at the time
the loan is made. Then the rate is tied to a recognized index your
lender is currently using for this loan. Your future interest adjustments
are then based on the upward or downward movements of this index.
An index is a reliable statistical report that reflects the approximate
change in the cost of money. Some examples of this would
be the monthly average yield on three year treasury securities, or the
national average mortgage contract rate for purchases on previously occupied
homes. The rise and fall of your payments will fluctuate with the
index preferred by the lender for this loan program when your loan was
made.
To
insure that the expenses of administration and profit are included in
the payments to the lender, it is necessary for the lender to add a margin
to the index. Different lenders use different margins which explains
the variation in interest rates offered for the same loan program.
Margins range from 2% to 4% and are added to the index to come up with
the interest rate you pay (margin + index = interest rate). It's
the fluctuation of the index rate that causes the borrowers interest rate
to increase or decrease.
ELEMENTS
OF AN ARM
 Index
 margin
 "Teaser
rates"
 Rate
adjustment period
 Interest
rate cap
 Mortgage
payment adjustment period
 Mortgage
payment cap (if any)
 Negative
amortization cap (if any)
 Conversion
option (if any)
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Lenders
generally use an index that will be responsive to fluctuations in our
economy  usually a oneyear Treasury security or the costoffunds
index (COFI). The costoffunds index is more stable than the
Treasury index because it doesn't rise or fall as sharply over the long
term as the Treasury index.
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MARGIN:
The
margin is the difference between the index rate and the interest charged
to the borrower. The margin doesn't change throughout the loan
term.
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"TEASER
RATES"
A
"teaser rate" is a reduced, firstyear introductory interest rate designed
to attract borrowers to ARM's. In the past, lenders were losing
money on fixedrate mortgages because these loans were yielding less
than the prevailing cost of money. Offering the adjustablerate
mortgage allowed lenders to insulate themselves from these losses and
increase earnings by passing the risk of interest rate fluctuations
on to the borrower. To make the ARM attractive to borrowers, a
low beginning interest rate was offered and through time these introductory
rates became known as "teaser rates". The interest rate would
then rise at each rate adjustment period until the rate equaled the
index rate + the margin. For example, let's say that the introductory
rate ("teaser rate") for your adjustablerate loan started at 4.5% interest
and would adjust upward 1.0% every six months. If your index for
this loan was 5.0% and the lenders margin was 3.0%, then the interest
on your loan for the first six months would be 4.5%. Six months
later, it would increase to 5.5% and so on until the fullyindexed rate
was reached. To find the fullyindexed rate, you would add the
index to the margin (5.0% + 3.0%). After the fullyindexed rate
was reached, your loan would then fluctuate with the index on your loan.
If the index goes up or down, your payment would increase or decrease
with the rise or fall of the index on your adjustment period change
date.
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RATE
ADJUSTMENT PERIOD:
The
borrowers interest rates on an adjustablerate mortgage are allowed
to be adjusted at certain intervals during the loan term. Depending
on the type of adjustable loan you have, this interval could be six
months, one year, three years or more.
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INTEREST
RATE CAP:
There
are limits on just how much your payments can go up if you have an ARM.
Usually these caps are in the form of interest rate caps and/or payment
caps. An interest rate cap determines the maximum number of percentage
points your interest can increase over the life of the loan.
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MORTGAGE
PAYMENT ADJUSTMENT PERIOD:
The
mortgage payment adjustment period is the agreed upon intervals at which
the payments of principal and interest are changed. The lender
can either adjust the rate periodically and adjust the mortgage payment
to reflect the change, or the lender can adjust the rate more frequently
than the mortgage payment is adjusted. For example, the loan agreement
may call for the interest to be adjusted every six months, but the payment
to be adjusted every three years. This scenario could be a problem.
If in the interim between payment periods (3 years), interest rates
have gone up or down too much, there will have been too much or too
little interest paid on the loan by the borrower over that period of
time, and the difference will be added to or subtracted from the loan
balance. When unpaid interest is added to the loan balance, it
is called negative amortization.
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MORTGAGE
PAYMENT CAP:
A
mortgage payment cap is the maximum allowable interest rate the lender
can charge on your loan regardless of what happens in the market.
Depending on your particular loan program, this is a percentage (usually
5% to 7.5% annually) that can be added to your fully indexed rate if
the market warrants moving that high. For example, if your fully
indexed rate is 8% and your annual cap is 6%, your loans life cap would
be 14%.
Mortgage
payment caps were designed to limit unrestricted increases by lenders
and keep the borrowers payments at a manageable level. Some lenders
impose payment caps, some impose interest rate caps and some lenders
use both.
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NEGATIVE
AMORTIZATION CAP:
A
negative amortization cap limits the amount of negative amortization
that can be reached on a loan. When the cap is reached, the loan
is reamortized to a level sufficient to pay off the loan over the remaining
term of the loan.
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CONVERSION
OPTION:
A
conversion option on an adjustable rate mortgage is called a Convertible
ARM. A conversion option gives the borrower the option to convert
their adjustablerate mortgage to a fixedrate loan. Convertible
Arm's normally have a higher initial interest rate (even the converted
fixed rate will usually be higher). You will usually have a time
frame in which to convert the loan to a fixed rate. For example,
you might have to make your decision to convert the loan sometime after
the first year and before the fifth year ends. In most cases,
there is also a conversion fee imposed on the borrower (for instance
1% of the total loan amount).
There are many different ARM programs to choose from with many available
options. If you are considering an adjustablerate mortgage, we
will be happy to explain your options to you and make sure you have the
right program to meet your needs.
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