Module 3 - Adjustable Rate Mortgages (ARMs)

(ARM) Periodic Cap Ex: If a previous period rate was 5% and the periodic cap is 2%, then what is the maximum change up or down?

2% = max change up or down 5% - 2% = 3% is lowest 5% + 2% = 7% would be the highest

(ARM) Fully Indexed Rate calculation ex. 4.25% current index value & 2% margin. ^What is the Fully Indexed Rate

4.25% current index value + 2% Margin = 6.25% Fully indexed rate

(types of ARMs) Option ARMs

(this kinda led to mortgage 2008 meltdown) 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 -Option ARMs offer a variety of payment options, such as: min payment (which can lead to negative amortization) a 15 yr or 30 yr amortized payment or an interest only payment ppl typically only paid min before 2008 which led to neg amortization

ARMs Scenario: Joe and Maria Sullivan are borrowing $280k toward the purchase of a home. The loan is 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 IR that could be charged in the 5th yr of the mortgage loan

5.625% + 4% = 9.625%

(ARM) Life cap Ex 2: If the start rate is 3% and the life cap is 6% then what is max the rate can reach over the life of the loan?

9% (3 + 6 = 9)

(types of ARMs) Option ARMs recasting

ppl typically only paid min before 2008 which led to neg amortization so the loans recasted where the lender looked at the loan and readjusted the loan (when there is too much negative amort) recasting- option ARM payments typically adjusted every 5 yrs. -lenders do this by amortizing the higher P balance created by the addition of I (negative amortization) -this automatic payment adj is called recasting -it amortizes the loan so it can be paid in full by the end of the loan term

(ARM) Rate Floor

rate caps (aka ceilings) generally protect the borrower, but the rate floor protects the borrower. a rate floor is sometime included in a lending agreement in order to protect the lender the rate floor is the lowest IR to which ARM may adjust for loans sold to Fannie or Freddie, the rate floor often = the margin

(ARM) Life Cap

sets max number of % points that the rate can increase over the start rate for the life of the loan functioning as a rate ceiling

(ARM) what is it called when introductory rate is lower than the fully indexed rate at time of closing?

teaser rate

(ARM) Life cap Ex 1: an ARM has an IR of 5.5% with a 6% lifetime cap. What is the life cap?

IR can NEVER exceed 11.5% (5.5 + 6.0 = 11.5)

Types of ARMs

IR only ARMs Payment-option ARMs Convertible ARMs Hybrid ARMs

Components of ARMs

-Index -Margin -Rate adjustment period -IR cap/floor (if any) -conversion option (can convert from ARM to fixed)

(ARM) Rate Cap Ex 1: Rate caps are more commonly shows as ___ numbers

2 numbers (remember these are cap rates!!!) EX: 2/6 2/6 = the first number indicates the max amount the IR can increase (or potentially decrease) from one adjustment period to the next) 2/6 = the second number indicates the max amount the IR can increase during the life of the loan

Where is Index specified to consumer for ARM loans?

2 places: Loan Estimate & Promissory Note when the loan goes to closing

(ARM) Some ARMs allow for a ______ rate change at the _______ adjustment and then apply a _______ adjustment cap to _______ adjustments (cont'd) these ARMs are usually identified with 3 numbers - for ex 5/2/6 so what does this mean?

5/2/6 5% at the first adjustment 1st number is the IR cap for the 1st adjustment 2% for subsequent adjustable periods. The 2nd number is the period adjustment cap 6% total over the life of the loan. The third number is the lifetime IR cap (it hit the "ceiling")

What is ARM?

Adjustable Rate Mortgages(ARM) - which frees lenders from being locked into a fixed-interest rate for the entire life of loan - IR adjust, based off index/current economic times, according to the terms in the note, to reflect the cost of money -ARMs are popular alternative financing tools as they may help borrowers qualify more easily for a home loan or a for a more expensive home (typically the IR is lower than fixed at beginning of loan payment period) - Many Lenders prefer ARM bc they pass risk of fluctuation interest rates on to borrowers

(ARM) Rate Cap Ex 2: An ARM has a start rate of 4% with 2/6 cap what is most the ARM can increase (or decrease) at each adjustment period? the most the rate can increase TO on the first period adjustment is ____%? the lowest the rate can decrease to on the next period adj is ____%? HOWEVER, the most it can increase over the life of the loan (life cap) is ____% from the start rate - so the highest the rate can ever be is _____%

An ARM has a start rate of 4% with 2/6 cap what is most the ARM can increase (or decrease) is 2% at each adj period. the most the rate can increase TO on the first period adjustment is 6%? (4% start + 2% adj per = 6%) the lowest the rate can decrease to on the next period adj is 2%? (4% start rate - 2% adj per rate = 2%) HOWEVER, the most it can increase over the life of the loan (life cap) is 6% from the start rate - so the highest the rate can ever be is 10% (4% start + 6% life cap = 10%)

Most Common Indices per ARM

CMT COFI LIBOR CODI Prime Rate (one of the most popular)

(ARM) Introductory rate

IR on an ARM at closing! and it will be in effect for a period of time ranging from 1 month - 10 yrs depending on loan product introductory rate aka: "start rate" "initial rate" *ALL introductory rates are set by Lender

(ARM) Indices Type (LIBOR)

London Inter Bank Offering Rates (LIBOR)

(ARM) Some ARMs allow for a ______ rate change at the _______ adjustment and then apply a _______ adjustment cap to _______ adjustments

Some ARMs allow for a higher rate change at the first adjustment and then apply a periodic adjustment cap to future adjustments

(ARM) Indices Type (COFI)

The 11th District Cost of Fund Index (COFI)

(ARM) Indices Type (Prime Rate)

The Bank Prime Loan Rate (Prime Rate) this is amongst most popularly used index

(ARM) Indices Type (CMT)

The Constant Maturity Treasury (CMT)

(ARM) Where is margin disclosed to consumer?

The Loan Estimate

(ARMs) Hybrid loans are often advertised as 3/1, 5/1, 7/1 or 10/1 ARMs what does this mean?

These loans are a mix (HYBRID) of a fixed rate period and an adj rate period. The IR is fixed for the first few years of these loans - IE: for 5 years 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 IR period will be -the second number tells how ofter the rate will adjust after the initial period

ARM is also referred to as ______?

Variable rate loan & interest van vary upwards or downwards over the term depending on money market conditions and agreed upon index IR on ARM only changes if the chosen index changes borrower's payments may stay the same for a specified time (typically 1 - 2 yrs) depending on the borrower's agreement w/ lender

(ARMs) Hybrid Loans

a hybrid ARM combines the features of a fixed rate loan with those of an adj rate loan (think of hybrid car... an electric component and a gas component)

(types of ARMs) Interest Only ARM (aka IO)

allows payment of I only for a specified number of yrs (typically between 3 - 10 yrs) - this allows the borrower to have smaller monthly payments for a period of time - after that, monthly payments increase even if the IR stay the same, bc the borrower must start repaying the principal and interest each month

(ARM) Fully Indexed Rate - How is this determined?

by adding the index to the margin, lenders calc the fully indexed rate INDEX + MARGIN = FULLY INDEXED RATE

(ARMs) Hybrid loans can also be advertised as 2/28 or 3/27 ARM

first number is how long the fixed IR per will be and second number is the number of years the rates on teh loan will be adjustable before the IR on the loan begins to adjust, the borrower can decide to sell the property or refinance the loan

(ARM) fully index rate

index + margin = adjustable IR the borrower pays on the loan

(ARM IR caps) what are the 3 main IR caps?

initial cap (how much can the IR go up very 1st time) periodic adjustment caps (limits the amount the interest rate can adjust up or down from one adjustment period to the next) lifetime caps (whats the max it can be)

Index relating to ARMs

is an economic measurement that is used to make periodic interest adjustment for an ARM -although the lender chooses the index used, the lender has no control over the measurement of the index -index aka / referred to as the cost of money -bc of mkt forces, the index fluctuates during the term of the loan, causing the borrower's IR to fluctuate

(ARM) Rate Cap aka IR cap

is the limitation on the amount that an IR may have an increase or decrease either at the adjustment date or over the lifetime of the loan aka "adjustment caps" this is to avoid payment shocks aka large IR fluctuations (large increase in IR)

(ARM) Rate Adjustment Period

length of time between IR changes on ARMs -rate cap can be applied to the ARM loan

(ARM) the margin is a _____ number that (is or is not?) subject to change during the term of a loan

margin is a fixed number that is NOT subject to change during term of loan

(ARMs) Convertible ARM

the ARM may have a conversion o0ption - making it a convertible ARM So... if consumer wants to change from an adjustable to fixed rate mort, a refi of the transaction is generally required; HOWEVER a convertible ARM allows a borrower to convert from an ARM to a fixed rate without going through the refi process :) -the lender may charge a 1 time fee at the time the loan is converted to a fixed rate - when the loan converts, it converts to the current prevailing rate

(ARM) Fully Indexed Rate

the combination of the index and the margin

(ARM) Margin aka __________

the number that a lender adds to an index to determine the IR of an ARM (margin is the profit Lender makes on top of the index rate) margin aka spread (the index + margin = the adjustable IR or fully indexed rate the borrower pays on the loan margin can vary greatly between different lenders margin is a fixed number that is NOT subject to change during the term of a loan margin represents the lender's operating costs & profit margin margin is disclosed on the Loan Estimate

(ARMs) what makes Hybrid Loans desirable for borrowers?

those who plan to sell their homes or pay off their loans within a few yrs the fixed rate feature gives the borrower some security with fixed payments in the initial term of the loan the adj rate feature is that the initial IRs on these loans are typically lower than a fixed rate loan Initially, a fixed IR exists for a period of 3,5,7,10 yrs

(ARM IR caps) What is large purpose of IR caps

to prevent payment shock to borrower with built-in protections (this is typically for large increase fluctuations in IR)