3.5 General Mortgage Knowledge: Adjustable Rate Mortgages (ARM)

Introductory Rate

- the interest rate on an ARM at closing. -It will be in effect for a period of time ranging from one month to 10 years depending upon the loan product. - This, whether teaser or not, are set by the lender

ARM

AKA Variable Rate Loan

Fully Indexed Rate

Index + margin.

Rate Adjustment Period

The length of time between interest rate changes on ARMs.

Life Cap

Example: If the start rate is 3% and the life Cap is 6%, then the maximum the rate can reach over the life of the loan is 9%.

2/6 ARM

- 2% - The first number indicates the maximum amount the interest rate can increase (or potentially decrease) from one adjustment period to the next. - 6% - The second number indicates the maximum amount the interest rate can increase during the life of the loan.

Option ARM

- A type of loan that allows the borrower to choose among several payment options each month. - This provides flexibility for borrowers by allowing them to choose the payment that suits their current financial situation. - Offers a variety of payment options, such as a minimum payment (which can lead to negative amortization), a 15-year or 30-year amortized payment, or an interest-only payment

Interest-Only ARM (IO)

- Allows payment of interest only for a specified number of years (typically between 3 and 10 years). - This allows the borrower to have smaller monthly payments for a period of time. - After that, monthly payments increase even if interest rates stay the same, because the borrower must start repaying the principal and the interest each month.

Hybrid Loan

- Combines the features of a fixed-rate loan with those of an adjustable-rate loan. - This ARM may be desirable for borrowers who plan to sell their homes or pay off their loans within a few years. - The fixed-rate feature gives the borrower some security with fixed payments in the initial term of the loan. - The adjustable-rate feature is that the initial interest rates on these loans are typically lower than a fixed-rate loan. - Initially, a fixed interest rate exists for a period of 3, 5, 7 or 10 years

Convertible ARM

- To change from an adjustable to a fixed-rate mortgage, a refinance of the transaction is generally required - However, this allows a borrower to convert from an ARM to a fixed rate without going through the refinance process. - The lender may charge a one-time fee at the time the loan is converted to a fixed-rate. - When the loan converts, it converts to the current prevailing rate.

Interest Rate Cap

-A limitation on the amount that an interest rate may increase or decrease either at the adjustment date or over the lifetime of the loan. -Used with ARMs to limit the number of percentage points an interest rate can be increased during the term of a loan, helping to eliminate large fluctuations in mortgage payments. - ARM loans help avoid payment shock with built-in protections. - Regulates how much the interest rate can increase in a given period.

Index

-An economic measurement that is used to make periodic interest adjustments for an adjustable-rate mortgage. -AKA Cost of money -Because of market forces, THIS fluctuates during the term of the loan, causing the borrower's actual interest rate to increase or decrease.

Hybrid ARM

-Often advertised as 3/1, 5/1, 7/1, or 10/1 ARMs. - These loans are a mix of a fixed-rate period and an adjustable-rate period. The interest rate is fixed for the first few years of these loans. - For example, for 5 years in a 5/1 ARM. After that, the rate may adjust annually (the 1 in the 5/1 example) until the loan is paid off. - The first number tells how long the fixed interest rate period will be. - The second number tells how often the rate will adjust after the initial period.

Most Common Indices

-The Constant Maturity Treasury (CMT) - The 11th District Cost of Fund Index (COFI) - The London Inter Bank Offering Rates (LIBOR) - Certificate of Deposit Index (CODI), and - The Bank Prime Loan Rate (Prime Rate).

ARM

-The interest on the loan varies upward or downwards over the term of the loan depending on money market conditions and the agreed upon index -The interest rate only changes if the chosen index changes. - The borrower's payments may stay the same for a specified time (for example one year or two years) depending on the borrower's agreement with the lender

Rate Floor

-the lowest interest rate to which an ARM may adjust. -Although rate caps generally protect the borrower, THIS is sometimes included in a lending agreement in order to protect the lender. -For loans sold to Fannie Mae or Freddie Mac, this is usually identical to the margin.

Hybrid ARM

A 2/28 or 3/27 ARM is another type of THIS ARM loan. - For this type of ARM, the first number is how long the fixed interest-rate period will be and the second number is the number of years the rates on the loan will be adjustable. - Before the interest rate on the loan begins to adjust, the borrower can decide to sell the property or refinance the loan. - The borrower takes a gamble with a hybrid loan by hoping that interest rates will be low when the note begins to adjust.

Payment Shock

A significant increase in the monthly payment on a ARM that may surprise the borrower.

Introductory Rate

AKA Initial rate or Start Rate

Margin

AKA a spread. -a fixed number that is not subject to change during the term of a loan. -represents the lender's operating costs and profit margin.

Recasting

An automatic payment adjustment - Option ARM payments are typically adjusted every 5 years. • Lenders do this by amortizing the higher principal balance created by the addition of interest (negative amortization). • It amortizes the loan so it can be paid in full by the end of the loan term.

Initial Cap

Applies only to the first rate adjustment period and indicates the number of percentage points that a rate may increase over the start rate.

1st Adjustment: 5.625% + 2% = 7.625% 2nd Adjustment: 7.625% + 2% = 9.625%

Because the Sullivan's are obtaining a 3/1 ARM, by their fifth year, the Sullivan' rate would have adjusted twice (once after the third year (hence 3/1 arm) and once after the fourth year). Calculate the rate adjustment.

Life Cap

Example - An ARM has an interest rate of 5.5% with a 6.0% lifetime cap. This means that the interest rate can never exceed 11.5% (5.5 + 6.0=11.5).

Periodic Cap

Example: - If a previous period rate was 5% and the periodic cap is 2%, then the maximum change is 2% up or down. - In this example, 3% would be the lowest and 7% would be the highest.

AKA Initial rate or Start Rate

Introductory Rate

5.625% + 6% = 9.625%

Joe and Maria Sullivan are borrowing $280,000 toward the purchase of a home. The loan is a 3-1 ARM with a start rate of 5.625%, a periodic rate cap of 2% thereafter, and a lifetime rate cap of 6%. They want to know the highest interest rate that could be charged in the fifth year of the mortgage loan?

Periodic Cap

Limits the amount the interest rate can adjust up or down from one adjustment period to the next.

Indices

Plural term for Index

Life Cap

Sets a maximum number of percentage points that the rate can increase over the start rate for the life of the loan functioning as a Rate Ceiling.

Teaser Rate

When it is lower than the fully indexed rate at the time of closing.

5/2/6 ARM

➢ 5% at the first adjustment. The first number is the interest rate cap for the first adjustment, ➢ 2% for subsequent adjustable periods. The second number is the period adjustment cap, and, ➢ 6% total over the life of the loan. The third number is the lifetime interest rate cap.