L13/C2: Methods of Financing/Fixed-Rate and Adjustable-Rate Mortgages

Stages of an adjustable-rate mortgage:

1. Initial Rate Period: The introductory period of an adjustable-rate mortgage loan in which the interest rate is locked at the initial rate 2. Adjustment Period: Set periods of time in which the ARM loan's interest rate can be adjusted 3. Lookback Period: The date when the index rate for the upcoming adjustment period is selected

Adjustable-Rate Mortgages Disadvantages

1. Interest rates change. If interest rates go way up, the borrower will end up paying way more than they began paying in the introductory interest period. 2. The borrower will have to be careful because sometimes the rate caps don't apply to the first adjustment. This is something they'll definitely want to negotiate with their lender. 3. If a borrower isn't super knowledgable about ARMs, they might have trouble negotiating with the lender because there's so much that goes into them. Lenders might use the borrower's lack of knowledge to sign them up for something that isn't very beneficial to them.

Types of Caps

1. Periodic rate cap: limits the change in interest year over year. 2. Lifetime cap (aka ceiling): limits the increase of interest for the life of the loan. 3. Payment caps: limit the amount of the monthly loan payment for the borrower, which is stated in dollars and not in percentage points.

Adjustable-Rate Mortgages Advantages

1. The big draw toward ARMs is the fact that they offer introductory interest rates that will be lower than fixed interest rates. 2. If interest rates are dropping, ARM borrowers will be able to reap the benefits without doing anything. They won't have to refinance to take advantage of lower interest rates. 3. If the borrower doesn't intend to stay in the house long, they'll be able to take advantage of cheap low rates before selling their house. If they sell before the adjustment, they won't have to worry about a payment increase.

Most mortgages are linked to one of three potential indexes:

1. the London Interbank Offered Rate (LIBOR) 2. the 11th District cost of funds 3. the maturity yield on one-year Treasury bills.

if the ARM's indexed rate is at 3% and the margin is 4%, the fully-indexed rate is going to be __________ .

7%

If a loan's margin is 2% and the index rate is 6%, the interest rate will be:

8%

If the margin on a loan is 3% and the index rate is 5%, the interest rate will be ________. If the index rate goes down to 3% at the next index reset period, the interest rate on the mortgage will be _____.

8%/6%

Fixed-rate mortgages are advantageous because:

Because of the stability, they'll be able to create a monthly budget and not have to worry about it changing because of the house payment.

Cammy takes out a fully-amortized, fixed-rate loan for her new vacation home on Lake Placid. When Cammy's mother asks her to fly to Singapore for their family vacation, Cammy tells her mother she doesn't know if she can afford it, as her loan payments could fluctuate. Analyze if Cammy is correct.

Cammy is NOT correct; she has a fully-amortized, fixed-rate loan, so she knows exactly how much her monthly payments will be.

Margin

The difference between the ARM's rate and it's eventual fully-indexed interest rate

Fully Indexed Rate

The rate you get when you add the index and the spread

rate cap

The stopping point for the interest on an ARM. These can limit how high the interest rate can go and also how big the difference can be between old and new payments.

What questions should your client pay attention to in order to determine what kind of loan they need?

What is the current interest rate, based on the Fed? Do they plan on staying in their house long? If the rates for the ARM do increase, would the borrower still be able to afford the payments? When looking at ARMs, they should check to see how often they adjust.

spread (also known as the margin)

a fixed amount above the index which the borrower will pay. This is given as a percentage to be added on top of the index.

Adjustable-rate mortgage (ARM)

a loan with an interest rate that can increase and decrease periodically throughout the life of the loan, often based on a market index.

What does a rate cap protect a borrower from?

a sudden and excessive increase in interest rate

benchmark (also known as index)

a way for investors to compare how this mortgage is doing compared to other similar types of mortgages. The benchmark/index is the number that adjusts when the time comes. It's the adjustable in adjustable rate.

What is the only thing that changes in a fully-amortized, fixed-rate loan?

how much of each monthly payment is applied to interest vs. principal

fully-amortized, fixed-rate loans.

loans where the interest rate remains the same for the life of the loan and the monthly payments remain the same.

The important thing to know about margin and index amounts is that the higher the margin, the ____________ , and vice versa.

lower the index level

ARMs are _______ with the lender

negotiable

What does the margin of an ARM tell you?

the difference between the ARM's rate and its eventual fully-indexed interest rate

Jeremy took out a 5/1 ARM. What does the 5 mean?

the interest rate is fixed for 5 years

ARM mortgages are written in fractions like 2/28. What does the first number represents? What does the second number represents?

the number of years that the interest rate is fixed for. The second number doesn't always mean the same thing but something to look at is the time before the rate fluctuates again. For this type of situation, it's important to make sure your client understands what the lender means by this number.

ARM's initial rate period

the period that an ARM's initial interest rate is locked for

fully indexed interest rate

when the the margin and the index are combined