Fixed-Rate and Adjustable-Rate Mortgages

a way for investors to compare how this mortgage is doing compared to other similar types of mortgages

Benchmark (also known as an index)

type of rate cap that limits the amount of the monthly loan payment for the borrower, which is stated in dollars and not in percentage points

payment caps

What is the lookback period of an ARM?

the date when the index rate for the upcoming adjustment period is selected

type of rate cap that limits the change in interest year over year

periodic rate cap

T/F - The higher the margin, the lower the index level will be.

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what are some disadvantages of a fixed rate mortgage?

1. If the interest rate is high when the borrower is trying to get a mortgage, their interest rate will stay high for the life of the loan. The only way they would be able to change their interest rate is to refinance, which can be helpful, but can also be a hassle. 2. If the interest rate drops by a lot, the borrower won't be able to take advantage of the drop. Again, their only option would be to refinance. 3. A lot of the time, fixed-rate mortgages are sold to the secondary market, while ARMs stay within the lender's institution. This means that ARMs can usually be more customizable than fixed-rate.

what are the disadvantages of an ARM?

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. Yikes! This is something they'll definitely want to discuss/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.

What is the adjustment period of an ARM?

set periods of time in which the ARM loan's interest can be adjusted

what are the advantages of an ARM?

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.

What are some benefits of a fixed rate mortgage?

1. The payments are always going to be the same. Whatever the interest rate might be in the world, the borrower is protected. 2. 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.

What are the stages of an adjustable rate mortgage?

1. initial rate period 2. adjustment period 3. lookback period

if the ARM's indexed rate is at 3% and the margin is 4%, what is the fully indexed rate? What if the ARM's index rate increased to 5%?

7%; then the fully indexed rate would increase to 8%

If the margin on a loan is 3% and the index rate is 5%, what is the fully-indexed interest rate? What if the index rate goes down to 3% at the next index reset period?

8% -if the index rate goes down, then the interest rate on the mortgage will be 6% (margin+index)

Jeremy took out a 5/1 ARM. What does the 5 mean? A. the interest rate is fixed for 5 years B. the interest rate will start at 5% C. the margin is 5 D. the loan has a 5 year term

A - The first number will always be the number of years that the interest rate is fixed for. So a 5/1 will have a fixed interest rate for 5 years.

If a loan's margin is 2% and the index rate is 6%, the interest rate will be: A. 8% B. 6% C. 2% D. 4%

A -If the margin is 2% and the index rate is 6%, the interest rate will be 8%.

How does a benchmark for an ARM work?

To find the benchmark for a specific mortgage, they look at things like risk and the style of the investment portfolio. This way, the mortgage has a standard that it can be compared to. The benchmark/index is the number that adjusts when the time comes. It's the adjustable in adjustable rate.

How often can a lender adjust the rate on an ARM?

After the initial rate period ends, the lender can then adjust the loan rate every new adjustment period.

What does the margin of an ARM tell you? A. the fully indexed rate as compared to the market value B. the difference between an amortized loan at market rate and the ARM's starting rate C. the difference between the ARM's rate and its eventual fully-indexed interest rate D. the market rate minus the fully-indexed rate

C - The difference between the ARM's rate and its eventual fully-indexed interest rate is known as the margin.

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; Cammy has a fully-amortized, fixed-rate loan, so she knows exactly how much her loan payments will be every month.

T/F - if the spread on a loan is 3%, then the borrower is always paying 3% above whatever the index is at the last adjustment

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the stopping point for the interest on an ARM is called _____

a rate cap

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

adjustable rate mortgage (ARM)

Why would a buyer initially choose to go with an ARM?

because an adjustable rate mortgage will typically have an introductory interest rate that is lower than the market rate for conventional loans.

What is a fully-amortized, fixed rate loan

in this kind of loan with this kind of interest rate, the interest rate remains the same for the life of the loan, and the monthly payments remain the same

An ARM's initial interest rate is locked in for a certain period of time. This is called the....

initial rate period

type of rate cap that limits the increase of interest for the life of the loan

lifetime cap or celining

Most mortgages are linked to one of three potential indexes. What are these indexes?

london interbank offered rate (LIBOR), the 11th district cost of funds, or the maturity yield on one year treasury bills.

The difference between the ARM's rate and it's eventual fully-indexed interest rate is known as the...

margin

What are the types of rate caps?

periodic rate cap lifetime cap or ceiling payment caps

The rate you get when you add the index and the spread is known as...

the fully-indexed rate

What is the initial rate period of an ARM?

the introductory period of an adjustable rate mortgage loan in which the interest rate is locked at the initial rate

What is the purpose of a rate cap?

the rate cap can limit how high the interest rate can go and also how big the difference can be between old and new payments

a fixed amount above the index, which the borrower will pay

the spread (or margin)

How does the spread work?

the spread is given as a percentage to be added on top of the index.

If you are reviewing an ARM being written up & you see 2/28. How many years will the interest rate be fixed for?

two years - the first number will always be the number of years that the interest rate is fixed for.