|
|
ARM's ExplainedFixed Rate Mortgages are easy to understand. Each loan has an interest rate and principal and interest payment that remain constant over the term of the loan. Adjustable Rate Mortgages, on the other hand, are a bit more involved.ARM's have both payments and interest rates that change periodically over the term of the loan. How often these components change, what the changes are based on, and the extent of the change differ depending on the type of ARM. An explanation of the terms associated with ARMS will help you to better understand them. Start Rate - This is the initial interest rate you are charged, and it's typically lower than current "market" rates as an inducement to do the loan (often called "teaser" rates). The start rate may last for 3 months, 6 months, 1 year, or for as long as 7 years. The longer the start rate is guaranteed for, the higher the rate. Index - In order to lend money to borrowers, the lender has to pay someone else for the use of their money. Many people invest in CD's, Treasury Bills, and the like for which they are paid interest. This is similar in concept to wholesale prices, so stated simply the index is the price the lender has to pay to get money to lend. (The different types of indices are explained in detail below). Margin - Essentially, this is the lender's profit margin and is added to the index to get the "fully indexed" rate at the time of each adjustment. The fully indexed rate can be thought of as the retail price...index (wholesale price) + margin (lender profit). Adjustment Date - The date on which your interest rate and payment changes based on fluctuations in the index. Depending on the type of ARM, this may be every month, every six months, once per year, etc. Term Cap - Also referred to as the Annual Cap, this limits how much the interest rate can fluctuate either up or down at each adjustment date. Typically, this is limited to 1% every 6 months or 2% per year for annual adjustments. Life Cap - This places a limit on how high your interest rate can go over the life of your loan, and is added to the start rate. For example, if you had a Life Cap of 6% and your start rate was 6.50%, the highest interest rate you could ever be charged in any given period over the life of your loan would be 12.50% (6.50% + 6.0%). Negative
Amortization - Some loans have negative amortization features,
which occurs if your payment is less than the interest being
charged each month. Certain ARM's have initial payments which
are guaranteed for one year, but the start rate may only be
guaranteed for 3 months. After 3 months if you continue to make
the minimal guaranteed payment, your loan balance will increase
by the difference between the interest charged and your monthly
payment. Negative amortization is not inherently bad, because
a loan with this provision still allows you to make a higher,
"normal" payment where all the interest plus principal is paid
each month. If anything, it gives you more downward flexibility
in your payment schedule should the need ever exist for you
to make less than the "normal" mortgage payment. The Most Common ARM Indices 1 Year T-Bill - This index is calculated by the Federal Reserve on a weekly basis, and is based on the average yield on 1 Year Treasury Bills issued by the Federal Government. The yield on the 1 Year T-Bill fluctuates as the inflation outlook changes, and responds quickly to economic changes. This is one of the most commonly used ARM indices. 11th District Cost of Funds Index (COFI) - This index is calculated monthly by the Federal Home Loan Bank of San Francisco, and reflects the weighted average of the interest rates paid by financial institutions in California, Arizona, and Nevada for savings accounts, CD's, money market accounts, etc. The COFI is one of the more stable indices, since the largest part of the index is interest paid on savings accounts. ARM's tied to this index tend to rise and fall more slowly that other interest rates in general. Prime Rate - The Prime Rate is used most often for second mortgages and home equity lines of credit, and is rarely used for first mortgages. The Prime Rate is defined as the base rate on corporate loans posed by at least 75% of the nation's 30 largest banks. 6 Month CD - A composite of what banks are paying on their 6 month Certificates of Deposit. This index moves less rapidly than the 1 Year T-Bill, but more rapidly than the 11th District Cost of Funds (COFI). LIBOR - A measure of the current commercial lending rates for a group of London banks (London Interbank Offered Rate). Similar to the Prime Rate, but it moves up and down more rapidly than most all other indices. View
a table of the current ARM
Indices.
|
