WRITTEN BY BENNY L. KASS
Question: We are first time homebuyers, and have just signed a contract to purchase a new home in Virginia. Interest rates appear to be reasonable, and the builder has given us a sizable credit to be used for closing costs. The builder has recommended we use a particular lender, and has strongly suggested we get an adjustable rate mortgage (ARM). We are interested in this kind of mortgage, but do not really understand how it works. What exactly is an ARM, and is this something we should consider?
Answer: Mortgage lenders are creative. When interest rates skyrocketed in the early l980’s, the mortgage financing industry began developing new and imaginative loans to meet everyone’s needs. Many of these mortgages have acronyms, and over the years there were such mortgages as GEMS (Growing Equity Mortgages), RAMS (Reverse Annuity Mortgages), SAMS (Shared Appreciation Mortgages) and of course ARMS (Adjustable Rate Mortgages).
Let us look carefully at the adjustable rate mortgage.
This was created in the early 1980’s when lenders were affected financially because homeowners were repaying their mortgage loans at 8%, 9% or 10%, while the cost of borrowing that money was more than 15%.
Lenders made a basic economic decision many years ago. The shorter the term of the loan, the lower the interest rate would be. Thus, today you can still obtain a fixed rate, 30-year mortgage, meaning that your monthly payment (principal and interest) is guaranteed to be the same each and every month. But the fixed rate, 30-year mortgage, although reasonably low today, still carries about the highest interest rate going.
Most adjustable rate mortgages are guaranteed to stay on the books for 30 years, but the interest rate is adjusted periodically. There are many variations on this adjustable rate theme. There is a 7-23, where the rate is fixed for the first 7 years, and then adjusts annually thereafter for 23 more years. If the rate is adjusted for 5 or 7 years, the initial rate will be lower than for a 30-year fixed rate mortgage, but higher than an adjustable rate mortgage that is adjusted every year.
Today, the most common ARMS are the 1 year, or the 5 year. But even with these common ARMS, prospective home buyers must shop around for the best deal. Consumers must also carefully inquire as to all of the terms and conditions before they commit themselves to any kind of mortgage financing. And in addition to asking questions, you should insist on getting a written statement from the prospective lender reflecting all that you have been told– and promised.
Here is what you should do:
Determine the initial interest rate. It is defined as the rate on which your loan will be based during the initial period – – whether it is 1, 3, 7 or 10 years.
Find out how many points the lender is charging. Each point equals one percent of the loan. Thus, if you are obtaining a 1 year adjustable rate at 6.5 percent, and the lender is going to be charging you 2-1/4 points, a loan of $150,000.00 will require you to pay $3,375.00 in points — up front — when you settle on your house. Points are not as common in today’s marketplace, but some lenders are still requiring that points be paid. And if you want to reduce the interest even lower, you can volunteer to pay a point or two; but please do your homework and your math. You don’t want to be throwing good money after bad. A good ballpark is that each point will reduce your rate by one-eighth of a percent. The ideal solution is to convince your seller to pay a point or two; you reduce your interest rate, and can deduct those seller-paid points on your income tax return.
Ask if the ARM is based on a negative amortization schedule. Although my experience is that most ARMS currently are not amortized on such a negative basis, I still have seen some loans with a negative factor built in. This means that although you may be paying a lower interest rate, perhaps 3 1/2 or 4% for the first few years, the interest still is being charged on your loan at a higher rate — for example 5 or even 7percent. If this is the case,
the extra interest, which is the difference between what you are paying and what is being charged you, is added to your mortgage balance. I cannot recommend the negative amortization mortgage under any circumstances.
Determine what the rate adjustment will be. Find out if there is a cap on the periodic increases and determine what index the lender uses as a base for calculating changes in the adjustable rate.
Generally, lenders look at the Federal Funds Rate, which is published by the Federal Reserve Board. Some lenders use an index known as LIBOR (London Interbank Offered Rate) while others may use such rates as (1) the current prime rate, (2) 10 year Treasury, or even Fannie Mae 30/60 . Ask your lender to provide youwith historical data comparing these various indices. Alternatively, you can find this information on the internet.
The lender then adds to that index number a rate adjustment, called a margin. If the adjusted rate is higher than the old one when your adjustment period comes due, your interest will be modified accordingly for the next set of payments.
For example, the current Treasury bill index for one year is 2.25%. The rate adjustment offered by the lender (the margin) is 3 points. Even if the Treasury bill index stays at the same next year, if you have a 1 year ARM, and your current rate is 3.25%, your new payment for the next year could be increased to 6.25% (3.25 plus 3).
However, if there is an annual rate cap, all yearly adjustments on your mortgage payments cannot exceed that cap. Thus, even if the index increases substantially, your new interest rate can only rise the first year not to exceed the cap. Clearly, you should insist on having your loan documents include a yearly cap.
Another point to consider is whether there is a ceiling on the overall amount that your rate can increase. Lenders realize that an ARM without such a ceiling is a potential disaster for consumers — and potentially bankruptcy and foreclosure for lenders. If you start with a 3.25% loan, for example, and there is a 2% point cap in the annual increases, it is conceivable that at the end of the 5th year, you would be facing a mortgage rate of 13.25%.
Most lenders, therefore, impose an overall ceiling on the amount that your interest rate can rise. However, make sure you fully understand what these ceilings are, and get them in writing before you commit yourself to an ARM or to a particular lender.
You should also make sure that your loan is, in fact, based on a 30-year amortization schedule. You also want written assurances that so long as you are current in your monthly mortgage payments, your loan will continue for a 30-year period. Some lenders have created adjustable rate mortgages that balloon at the end of a particular period of time — for example, ten years. This means that while the lender will probably renew your loan, it reserves the right to call it due at the end of the 10th year, depending on many circumstances, all of which must be outlined in writing to you before you commit yourself to that particular kind of loan.
There are also serious problems with interpreting how the rate adjustments work after you get the loan. Anyone with an ARM is advised to carefully review their original loan documents, to determine whether the lender has properly and correctly assessed the new adjustable rate, when the adjustment period comes due.
There have been a number of economic analysis studies throughout the United States, which have concluded that lenders have made a number of mistakes. Ironically, not all of the mistakes were in the lender’s favor.
You also indicated that your seller was recommending a lender. Make sure you shop around before you commit yourself to any loan.