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The margin is the markup that lenders charge on the money they are
lending. It is usually somewhere around 2.50%. The margin does not
change during the life of the loan. If your lender offers you various
margins, you should consider the lower margin since it will have
an impact on how much your rate will increase during the loan term.
It is the index plus the margin that gives you the fully indexed
rate. This is the rate that your loan should actually be at according
to current market conditions. If you have a low start rate, you can
be sure it will adjust to the maximum amount it is allowed to at
every adjustment period until it reaches the fully indexed rate.
Remember though, that the fully indexed rate will change because
the index changes, even though the margin does not.
It is important to find out how often the particular ARM loan you
are looking at will adjust. Adjustments are usually every 6 or 12 months.
If your loan adjusts monthly this should alert you that this loan might
have negative amortization. Negative Amortization loans will be discussed
later in this chapter.
The lender must inform you before your interest rate is about to adjust.
There are usually limits built into the loan as to how much the rate
can increase at any one time. These limits are known as periodic rate
caps. When shopping for an ARM loan always find out how often the loan
will adjust, and what the interest rate caps are.
There are two types of rate caps. There is the periodic adjustment
cap and the lifetime cap. The periodic adjustable rate cap limits the
maximum rate change, up or down, allowed for each adjustment. If your
ARM adjusts every 6 months, the periodic cap is usually 1% (one percentage
point above your current rate). If your ARM adjusts every 12 months
the periodic cap is usually 2%.
You should never take an ARM without a lifetime cap. This cap limits
the maximum amount the interest rate can adjust over the life of the
loan. ARM loans usually have a lifetime cap of 5 to 6 % above the start
rate of the loan. When deciding on an ARM loan always figure your payment
at the maximum rate. This way you will know in advance the very worst-case
interest rate for your loan.
Some loans have caps for the amount of your monthly payment. At first
this may appear to be beneficial because even though your interest
rate might be at the fully indexed level, your payment will only adjust
a certain percentage each year. This is a negative amortized loan.
With this type of loan you may get a low starting interest rate for
the first 3 months and then the loan will go to the fully indexed rate.
Even though the rate has adjusted to the fully indexed rate, your monthly
payment will increase only once per year. When it does increase, it
can only increase by a certain percentage from what it was. This is
the payment cap.
When you have a loan where the payment does not adjust to meet the
interest rate being charged on the loan, you are not paying
off all of the interest each month. What then occurs is the unpaid
interest is added on to the balance of your loan. You are not fully
paying off your mortgage over the 30 year period as you would in a
fully amortized loan over 30 years.
This type of loan does have some benefits. It is usually easier to
qualify for and can help out buyers who are having problems qualifying
at the standard 30 year fixed rate. It also usually offers the borrower
an option on how they wish to pay the loan off each month. They can
pay the fully amortized payment, and not allow the loan to go into
negative amortization. They can pay the full interest only payment,
which does not pay the mortgage down but also does not add to the mortgage
balance. They can pay the fully amortized payment for a 15-year loan
and pay the balance in full in 15 years. They can also pay the smallest
payment allowed which is at the payment cap and allows the loan balance
to increase. If your negative amortization loan has this feature, you
can usually choose each month which payment option you want to take.
This can often make this type of loan very flexible. It is important
to remember though, that if you are the type of borrower who will more
then likely always pay the minimum due each month, this type of loan
is probably not for you.
Before you make your final decision on an ARM loan you should ask
yourself the following questions:
1. Have you budgeted for higher mortgage payments? Can you afford
to pay the increases in your mortgage and still be able to accomplish
your other financial goals?
2. Will you have at least 6 months worth of living expenses left
over in an accessible account after close of escrow? This will help
to cover rising mortgage payments.
3. Do you know that you can pay the highest payment your ARM loan
may reach? This is the payment if the interest rate on the loan were
to reach the maximum rate possible. Your lender should be able to
tell you this payment.
4. If you are borrowing the maximum amount allowable for the sales
price of the house, do you have a stable job and steady income? Do
you expect the size of your family to change in the near future?
It is important to budget for any possible life changes.
5. Will an increasing mortgage payment create undo stress in your
life? If you are the type of individual that does not easily handle
changes such as this, an adjustable mortgage may not be a good choice
for you.
An adjustable rate mortgage could very well save you money over a
fixed rate mortgage over the life of your loan. Consider if you are
financially and emotionally secure enough to handle the maximum possible
payments over the life of the loan.
Also consider the length of time you expect to be living in the home.
If you don’t plan on staying there for a long period of time,
(usually more than 5 years) an ARM loan might be a good idea. For the
first 2 –3 years of an ARM loan you can usually save money over
the prevailing 30 year fixed rate.
If you expect to hold on to your home for a longer period of time,
a fixed rate loan can be the best way to go.
In addition to the four basic components, an ARM usually contains
certain consumer safeguards such as interest rate caps, which limit
the amount that the interest rate applied to the payments may move.
This prevents the amount of interest the consumer pays from rising
higher than perhaps the homeowner can afford. For instance, a typical
ARM would have a six percentage point cap over the life of the loan.
That means a loan with an initial interest rate of 6.25 percent would
be able to go no higher than 12.25 percent over the life of the loan,
and it would be able to move no more than two percentage points per
year.
Another safeguard found on some ARMs are monthly payment caps that
limit the amount homeowners need to increase their payments at adjustment
time. Monthly payment caps can, however, sometimes prevent the monthly
payments from increasing enough to keep up with the rise in the interest
rate, causing negative amortization-resulting in higher or more payments
for the homeowner later on.
Other options you should ask about when shopping for an ARM are:
- Assumability, or whether you may transfer the
mortgage to a new home buyer, usually with the same terms if the
new home buyer qualifies for the loan. ARMs are almost always assumable.
- Convertibility allows the borrower to change
an ARM to a fixed-rate mortgage, usually at the end of some predetermined
period, locking in a lower interest rate.
A relative newcomer in the mortgage market is a Reverse Annuity
Mortgage (RAM). For older Americans, especially retirees
living on fixed incomes, the equity in their paid-for or almost-paid-for
home represents a large but liquid asset. The RAM is designed to
help supplement those homeowners' income.
The lender who will issue a RAM appraises the property and makes the
loan based on a percentage of its current value. The homeowner retains
ownership, and the property secures the loan. The lender then pays
an annuity to the borrower, usually on a monthly basis, up to an amount
equal to the equity they have in the home.
The advantage of such a loan for older Americans is that of receiving
a monthly tax-free income. Under one plan, this income is available
for life or until the house is sold or the homeowner moves. The schedule
of payments depends on the value of the home and the ages of the owners.
There are risks involved, however. If the homeowner wants to move and
buy a new house, there may not be enough equity in the home to permit
such a plan. Or the lender may consider only the current market value
of the home rather than any future appreciation when deciding on the
monthly payments.
The Federal Housing Administration (FHA) and the Veterans Administration
(VA) offer a wide range of mortgage choices that may appeal to you.
These include 30 and 15 year fixed- rate mortgages, as well as ARMs.
Insured by these government agencies, the loans feature low or no down
payment terms and are often assumable by future purchasers. VA loans
are restricted to individuals qualified by military service or other
entitlements, but FHA - insured loans are open to all qualified home
purchasers. Note that there are limits to handle moderate-priced homes
anywhere in the country. Talk to your lender about FHA/VA possibilities.
This type of financing became popular when interest rates went to
very high levels in the early 1980s. Seller-assisted creative financing
usually means the seller of the home helps with financing by underwriting
all or part of the loan.
The advantage of this type of arrangement is the mortgage usually
carries a lower interest rate with lower monthly payments. The disadvantage
is the previous homeowner, not an institution, may hold the deed of
trust. If the loan terms call for certain payment schedules, the buyer
may have to seek new financing. Many home buyers in recent years have
found "creative financing" deals to be fraught with problems and
useful only as short-term alternatives to mortgages from traditional
lenders.
One type of mortgage you are apt to run into with seller financing
is the balloon payment mortgage. Balloons, as they
are known, are usually offered as short-term fixed-rate loans. The
balloon payment mortgage gets its name from the payment schedule, which
involves smaller payments for a certain period of time and one large
payment for the entire amount of the outstanding principal. They have
terms of 3, 5, and sometimes 15 years, though payments are usually
calculated as though it were a 30 year loan. Sometimes a balloon will
be offered as a second mortgage where you also assume the homeowner's
first mortgage . The major disadvantage with a balloon payment loan
is that it may be difficult to save the money to make the final large
payment (often the entire amount of the principal) while paying interest
on the loan. Some lenders guarantee refinancing, though the interest
rate is usually adjusted when the principal comes due. If you cannot
refinance, you may have to sell the property if you cannot meet the
large payment. Balloons are an advantage if you plan on living in an
appreciating house for a short period of time and want to pay less
while you live there.
There are several ways. First, talk with your real estate agent or
broker. Real estate professionals are normally in the best position
to learn about financing opportunities in the marketplace. Lenders
regularly call agents to alert them to financing packages. And, of
course, agents are highly motivated to obtain financing for their buyers.
Without a suitable loan, the sale can't proceed, and agents won't get
their sales commission on the house.
Second, look for rate surveys in your local newspaper. Many now include
brief tables on interest rates and mortgage availability in their real
estate or business section. They can help guide you to sources you
have not thought about.
Third, look in the Yellow Pages under "Mortgages," and shop for quotes
by telephone. Call five to 10 different lenders for rates and terms
on fixed and adjustable loans.
Finally, if your area is covered by one of the many commercial computerized
mortgage shopping services, give it a try. You may find,
however, that the computer services have only a selection of local
lenders on their listings.
One important method is by bearing in mind that mortgage packages
consist of more than interest rates. They consist of a quoted rate,
plus discount points (pre-paid interest assessed by the lender at settlement,
or the meeting when the property legally changes hands) and other fees,
plus a full range of terms including adjustable versus fixed-rates,
low down payment versus high down payment, the presence or absence
of prepayment penalties, and many other features noted earlier in this
brochure.
When you call around to different mortgage lenders, you might find
one lender quoting you an interest rate of 7% for a 30 year fixed rate,
while another lender quotes you a rate of 6.75%. If you automatically
jump at the lower rate of the two, it could end up costing a lot more
money.
Remember, an interest rate quote always goes along with points to
be paid on the loan. A lender can quote you varying interest rates,
and almost always the lower rate has the higher points.
Points are charged by the lender as a way to pay for the expense and
work associated with obtaining you a mortgage loan. When comparing
rates it is always important to also calculate the points involved.
One way to do this is to calculate the difference between the payment
for the 7% loan and the 6.75% loan. Now you know how much you would
save each month if you took the lower interest rate.
Next, compare the points. A point is 1% of the loan amount. So if
your loan is $100,000 one point would be $1,000. Let’s say the
interest rate of 7% is for a one point loan or $1,000. Maybe the points
for the 6.75% loan are 1.50% or $1500. You will then be paying $500
more in points for the lower rate. If the difference in payment is
$33.23 per month, how long will it take to make up for paying the extra
$500? If you divide $500 (the difference in the cost of the points)
by $33.23 (the monthly savings) you will get 15.05. It will take 15
months to break even. After 15 months you will actually be saving money.
If you plan on keeping this house for a long period of time and staying
in this mortgage you will be saving a lot of money over the life of
the loan. After the first 15 months you will save $398.76 per year
if you take the lower interest rate.
Also consider the tax benefits. Points paid on the purchase of a home
are tax deductible. You can claim them as an itemized expense on schedule
A of IRS form 1040.
If you have the cash, and will live in the home for a long period
of time, you will want the lowest interest rate you can get. Paying
the extra points required to get the lower interest rate can be a good
idea if you work out the cost and the months of lower payments required
to make this cost up.
If you are strapped for cash and can come up with the down payment
and minimal closing costs there won’t be a lot of money to pay
points. If you plan on living in the home a short period of time, paying
less in closing costs and a little more each month makes good sense.
If someone quotes you a no point loan, don’t automatically think
you are getting a deal. This is also true of a no point – no
fee loan, where you do not pay any fees at all for the loan. Remember
the rates/points tradeoff. You don’t get something for nothing.
A no point loan may make sense if you have very little funds available
for closing costs. You will also find that homeowners who refinance
over and over again like to have a no point loan. This way they can
refinance into another interest rate whenever rates decline and not
be concerned with the added expense of paying points to do this. They
still will not be receiving the best rate available, but it can still
work to their advantage if they think rates will be going even lower
and will want to refinance again, or will not be staying in this home
that much longer anyway.
One way to evaluate rates, however, is by examining the Annual
Percentage Rate (APR). The APR can help you compare different
types of mortgages. It indicates the "effective rate of interest" paid
per year. The figure includes discount points and other charges and
spreads them out over the life of the loan.
By law, the APR must always be disclosed to you within three days
after applying for a loan. The APR is the effective interest rate for
loans that are repaid over their full term. The APR calculation assumes
you will be keeping your loan for its full term. However, most people
sell or refinance their loan within 6 to 12 years. If a $100,000 loan
were repaid after 6 years rather then the usual 30, the effective interest
rate would be 8.66%; not the 8.32% APR you would be quoted. A fairly
accurate way to estimate the APR for comparison is:
Effective interest rate = quoted rate + (number of points / 6) If
you plan to stay only 4 to 6 years, divide the points by 4. If you
plan to stay for 1 to 3 years, divide the points by the number of years.
While the APR provides you with a common point for comparison, look
at the whole product before deciding which mortgage to get. Pick the
one with the rate, payment schedule and other terms that suit your
situation best.
To compare costs when shopping for loans ask lenders to quote a rate
based on the same points (a one-point loan is good for comparison).
That way you can generally see which lender has the better rate. Don’t
forget to compare the APR also, to ensure the lender with the better
rate/point quote isn’t adding on additional fees. Always ask
a lender whose loan you are considering to provide you with an estimated
breakdown of closing costs. That way you can compare more accurately.
- Acceleration Clause
- If you miss a monthly payment, an acceleration clause allows
the lender to speed up the rate at which your loan comes due
or even to demand immediate payment of the entire outstanding
balance of the loan.
- Assumability
- Assuming a mortgage is simply taking the loan over from the
holder (seller) and becoming liable for the repayment.
- Buydown
- The Buydown mortgage is one where the seller and/or the home
builder subsidizes the mortgage by lowering the interest rate
during the first few years of the loan. While the lower initial
payment and interest rate make this kind of loan easier to qualify,
the payments may increase when the subsidy expires.
- Closing Costs/Settlement Costs/Escrow
- Closing costs are the costs associated with settlement, the
meeting where the buyer and seller (or their agents) sit down
to fill out the papers and make the exchanges that allow the
property to legally change hands. Closing costs include appraisal
fees, title search and insurance, survey, tax adjustments, deed
recording fees, credit report and points, among others.
- Due-on Sale Clause
- A clause or provision in a mortgage or deed of trust that allows
the lender to demand immediate payment of the balance of the
mortgage at the time of sale.
- Negative Amortization
- This occurs when your monthly payments are not large enough
to pay all the interest due on the loan. This unpaid interest
is added to unpaid balance of the loan. The danger of negative
amortization is that the home buyer could end up owing more than
the original amount of the loan.
- Private Mortgage Insurance
- In the event that you do not have a 20 percent down payment,
lenders will allow a smaller down payment-as low as 5 percent
in some cases. With the smaller down payment loans, however,
borrowers are usually required to carry private mortgage insurance.
Private mortgage insurance will require additional premium
payment of 0.5 percent to 1.0 percent of your mortgage amount
plus an additional monthly fee depending on your loan's structure.
On a $75,000 house with a 10 percent down payment, this would
mean an initial premium payment of $338 to $675 and an extra
$15 to $20 a month.
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