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Bruce Specter offers this information as a guide to alternatives to the traditional 30 Year Fixed Rate Mortgages. Though interest rates have remained fairly low, the Adjustable Rate Mortgage (ARM) makes a financially smart alternative for a number of situations. As with everything I do, providing you information to make an informed decision is key to making a sound choice. Contact Bruce Specter at any time for additional information on any of these topics.
Adjustable Rate Mortgages (ARMs) Are Still Viable
Which ARM is the Best Alternative
Is an Option ARM Right For You?
Even as they inch up a bit, today's mortgage rates still look like a bargain.
Back in September 1981, the FHA (which used to set nation-wide interest rates for all the mortgages it insured) was asking 17.5%. And people who needed to buy, were paying rates like that in the early 1980s. (We can only hope they've paid off those loans early refinanced to something a bit lower by now.)
Those were the days when bankers, trying to find something people could afford and wishing they could get free of old 5% loans, invented all sorts of new mortgage plans: graduated payment plans, rollover mortgages, shared equity loans, and pledged account mortgages. When the dust had settled, the new arrangement that became part of the standard array of mortgage offerings was the adjustable rate mortgage.
The adjustable rate mortgage shifts the risk of changing rates to the borrower. If rates in general fall, the borrower can benefit next time the monthly payment figure is adjusted. If rates rise, so will the borrower's interest.
And to make the plan attractive to homebuyers, the adjustable rate usually carries an appealing initial interest rate - lower than average current levels. To some homebuyers, this looks like a "come on, the first one's free" ploy. They inquire "what would my payment be if this were adjusted to the rate your long-time borrowers are paying by now?" And they usually opt, these days, for fixed-rate loans, to lock in today's relatively low rates for the next 25 or 30 years.
But there are some buyers (a minority these days) who choose adjustable rate mortgages (ARMs) for good reasons.
Certain ARMs won't adjust for long periods. The low initial rate may last for three years, five years, or sometimes even seven years. The buyer who doesn't expect to live in the house any longer than that may jump at the lower monthly payments.
It's always prudent to ask, however, what happens to the shortfall when the payment doesn't cover today's true cost of money. In a few instances, the money that isn't being billed is added to the amount of the loan -- a condition called negative amortization. At the end of the year, the borrower owes more than at the start. Again, though, even that might not worry the buyer in an area where prices are skyrocketing, so that the sale will more than take care of the problem of paying off the higher loan.
For someone who anticipates rising income (a professional just starting out, for example), qualifying for the lower rates on an ARM can mean borrowing more and thus buying a more ambitious house.
And if rates ever shoot up to 17% again? We'll face that problem if we come to it.
Low inflation, low unemployment, and low interest rates have fueled a nearly perfect home market in recent years, and home sales have soared. Now it is time for a normal adjustment. Rising fuel costs and other indicators show the need to head off inflation. The Federal Reserve does that by raising interest rates to slow things down a little. In February, the Fed is certain to raise interest rates again.
That means if you are a homebuyer, you can prepare to pay more for a home than last year, and pay at a higher interest rate. Does that mean you can no longer afford the home of your dreams? Not necessarily.
One of the great things about shopping for a home today is that lenders have a wide offering of loan products that will get you into the home you want at a price you can afford. The only dream you may have to give up is having a fixed rate mortgage.
The 30-year fixed rate mortgage is considered the gold standard of loans. It is one of the rewards of having good credit, but there are times when they don't make the most sense for you or your family. Two scenarios that come immediately to mind is if you and your family are planning to move again within three to five years, and if interest rates have risen to the point that you no longer qualify for a 30-year loan on the home of your dreams. If you want that home, you have to look at alternatives in financing.
The adjustable rate mortgage (ARM) is basically a shorter term, higher risk loan, but it is hardly on a second string loan product. In fact, it's a sensible loan alternative that has gained greatly in status in this new technology-driven economy. Many financial strategists, who view the home purchase as the greatest of personal investments, believe in the ARM as a means of leveraging your credit and financial means to the fullest.
Risk is calculated on an ARM. You can choose a loan with a "cap" - no more than two percentage points a year and ceiling of six points for the life of the loan, for example. That way you know up front what the worst case scenario will be should the loan go up.
The 30-year loan means that the bank shoulders the responsibility for your loan for the full term, raising the lender's risk. That's why only those with good credit need apply. But the ARM, at one or two percentage points lower in interest costs, means that you share more in the risk, but the reward is that you can buy that much more home for the money. Sounds like smart strategic planning, when you look at it that way.
New loan products, called hybrid loans, offer a short fixed rate term that rolls over to an ARM after a specified period. This lowers the risk and the cost for the borrower as well as the bank. Hybrid loans are perfect for the family who is not certain they are staying in the home for long, or for those who want to buy more home for the loan and gamble that the adjustable rate will go down later on. Some loans give you the option of renegotiating the terms after the fixed rate period has ended - you can go adjustable again, or if conditions favor, get your coveted 30-year or 20-year note after all.
The advantage is that you can still jump into the housing market knowing that if you find that perfect home, there is a financial product available that will allow you to buy it, and at terms you can afford.
Check with your lender and ask about an ARM, or a hybrid loan today.
How would you like a mortgage loan where you did not have to make the whole payment if you did not want to? Or would you like a loan with an interest rate about one percent below a thirty-year fixed rate mortgage and pay zero points? Or a loan where you did not have to document your income, savings history, or source of down payment? How would you like a mortgage payment of only 1.00 percent? You can have all that with the 12 Month Treasury Average (MTA) Adjustable Rate Mortgage.
Sound too good to be true? Sound like a bunch of hype?
Each statement above is true. However, it is also only part of the story and loan officers do not always tell you the whole story when promoting this loan. Then other loan officer try to scare you away from the adjustable rate mortgages. However, once you become aware of all the details of the loan, it is an excellent way to buy the house of your dreams, especially when fixed rates begin to go up.
ARMs in General
Adjustable rate mortgages all have certain similar features. They have an adjustment period, an index, a margin, and a rate cap. The adjustment period is simply how often the rate changes. Some change monthly, some change every six months, and some only adjust once a year. Indexes are simply an easily monitored interest rate that moves up and down over time. Adjustable rate mortgages have different indexes. The margin is the difference between your interest rate and the index. The margin does not change during the term of the loan.
So if you have an adjustable rate mortgage and you wanted to calculate your interest rate on your own, all you have to do is look up the index in the paper or on the internet, add the margin, and you have your rate.
Indexes and the MTA
The "Prime Rate" you hear about in the news is one interest rate index, although it is very rare that mortgages are tied to this index. It is more common to find adjustable rate mortgages tied to different treasury bill indexes, the average interest rate paid on certificates of deposit, the London Inter-Bank Offered Rate (LIBOR), and the 11th District Cost of Funds. Currently, the MTA is the lowest of these indexes, though this is not always true.
To simplify, the Monthly Treasury Average is a relatively new ARM index. This index is the 12 month average of the monthly average yields of U.S. Treasury securities adjusted to a constant maturity of one year. It is calculated by averaging the previous 12 monthly values of the 1-Year CMT. Because this index is an annual average, it is more steady than the 1-Year CMT index. The MTA index generally fluctuates slightly more than the 11th District COFI, although its movements track each other very closely (as illustrated on our historical graph).
The Margin and Interest Rates
The margin on the MTA ARM can be on either side of 2.5%. For example the MTA index as of January 22, 2008 is 4.326%. With a margin of 2.5%, your interest rate would be 6.826%. During this same time, thirty year fixed rate loans on conforming mortgages are hovering just below 6%. This makes the longer term loan more attractive over the life of the loan. Fixed rates on jumbo loans (above $417,000) are higher (by roughly 1%.
Monthly Adjustments Sound Scary, but..
Although you can get a ARM with an adjustable period of 6 months, you can get a lower margin if you go for the monthly adjustment period. Since the margin plus the index equals your interest rate, the lower margin is an advantage and most people choose the monthly adjustment.
Monthly adjustments sound scary to the uninitiated, but keep in mind that this is a slow moving index. Most other ARMS have an annual cap of two percent a year. Since 1981, when the FHLB began tracking the index, the most it has moved during any calendar year is 1.6%. So why get a higher margin just to get a rate cap that you probably will not use anyway?
The "life-of-loan" cap for the MTA ARM is usually 11.95%. The most recent year that this cap could have been reached was 1985. Plus, most experts do not expect a return to the interest rates of the early 1980's when interest rates were pushed up artificially to combat the inflation of the 1970's.
Make Only Part of Your Payment?
This is the really interesting feature of the loan. You do not have to make the whole payment. Each month you get a bill that has at least three payment options. One choice is the full payment at the current interest rate. A second choice allows you to pay only the interest that is due on the loan that particular month, but does not pay anything towards the principal. Finally, the third option gives you the choice to pay even less than that and is called the "minimum payment."
The minimum payment when you start your loan can be calculated as low as 1.25 percent. Keep in mind that this is not the note rate on your loan, but just a way to calculate your minimum payment.
Deferred Interest and Amortization
Of course, if you only make the minimum payment each month, you are not paying all of the interest that is currently due that month. You are deferring some of the interest that is currently due on the loan and you will pay it later. The lender keeps track of this deferred interest by adding it to the loan and the loan balance gets larger. Neither you nor the lender wants this to continue forever, so your minimum payment increases a bit each year.
The payment cap on the loan is 7.5%, which also has nothing to do with the interest rate. All it means is the most your minimum payment can increase from one year to the next is seven and a half percent. For example, if your minimum payment is $1000 this year, next year the most it could be is $1075. This continues each year until your payment is approximately equal to the payment at the full note rate.
Just in case, there are fail-safes built into the loan. If you continue making the only the minimum payment and your current balance ever reaches 110 percent of the beginning balance, the loan is re-amortized to make sure you pay it off in thirty years (or forty years, whichever option you chose). Every five years the loan is re-amortized to make sure it pays off within the term of the loan.
Stated Income and Other Features
Many lenders allow homebuyers with good credit to apply without documenting their income, assets, or source of down payment. Of course, you have to make a twenty or twenty-five percent down payment on your home purchase. This is helpful for self-employed borrowers or those who have jobs where it is difficult to document their income. Plus, some people just do not like the bother of supplying W2 forms, tax returns and pay-stubs. Anyway, it makes for a quick and easy loan approval.
Sub-Prime ARMs
Some people have less than perfect credit and they are used to being charged outrageous rates for past problems. Some lenders offer this same loan but have a slightly higher starting payment and a higher margin. The end result is that your interest rate would be about one percent higher. As of August 18, 1999, that would be around eight percent on this loan instead of seven percent.
Who Should Get This Loan?
In my personal experience, most people who get the MTA or LIBOR ARMs are purchasing a home between $300,000 and $650,000, but it is not limited to that. It is a real favorite of those working in the financial industry and those with higher incomes. One reason they like it is because they consider any deferred interest to be an extended loan at a very attractive rate. By making the minimum payment, they do other things with the money.
Homebuyers whose income has peaks and valleys, such as self-employed or commissioned salespeople also like the loan, because it provides flexibility in the monthly payment. During a slow month they can make the minimum payment if they choose.
Another reason borrowers like the loan is because it allows for tax planning. The borrower can defer interest payments and at the end of the year, analyze their tax situation. If it serves their tax interests, they can make a lump sum payment toward any interest that has been deferred and deduct it for tax purposes.
Skipping the Starter Home or Move-Up Home
If you're buying a home with the intention of living in it for only a few years before you move up to a bigger home, the MTA or LIBOR ARM makes sense, too. With this loan and its low start payment you can often qualify for a larger home than you can when applying for a fixed rate loan. This allows you to skip the intermediate purchase and move up immediately to the home you really want, which makes more sense and saves you money.
If you buy a home, then sell it to move up to a bigger home, you are going to have to pay Realtor's commissions and closing costs. On a $300,000 house, this would be around $25,000. If you skip buying that home and buy the home you really want, you save that money. Plus, you save money in another way. Say you live in your intermediate purchase for five years, then move up and buy another home with another thirty year mortgage. That is thirty-five years of home loans. If you buy your ideal home now, you save five years of mortgage payments. Depending on your loan amount, that can be a lot of cash.
Conclusion
So, when rates start going up this is an attractive alternative to fixed rates. It even makes sense for some borrowers when rates are low. Something we also did not mention is that most MTA and LIBOR lenders also give you a fourth option on your monthly mortgage statement which allows you to pay it off quicker.
We've really seen low rates this year, some reaching near the levels not seen since the fall of 1998. Many who refinanced their loans locked in the low, long term fixed rates. Still others got an even lower rate....they got a hybrid loan.
What's a hybrid mortgage?
Mortgage hybrids are a cross between and fixed rate and adjustable-rate mortgages. They generally have fixed rates for the first three, five, seven, or ten years and then they convert to adjustable-rate mortgages (ARMs) for the remainder of the loan term.
A "5/1 ARM" is an ARM that is fixed for five years, then turns into a 1-year adjustable mortgage. A "3/1 ARM" is fixed for three years, and so on.
Hybrid loans are sometimes also called "two step" financing and can be described as 3/27, 5/25, and 7/23 loans as well. Of course, whatever the loan is called, be certain you understand all costs, terms and conditions.
With hybrid loans the fixed rates are established up front and -- of course -- do not change during the first part of the loan term. Once the fixed-rate portion of the loan ends, the mortgage then behaves like an ARM with rate changes and monthly payments moving up or down each year as interest levels evolve.
ARMs are based on an agreed upon index, with common indices being the 1-year Treasury (sometimes called the 1-year T-Bill), a 6-month CD, the 11th District Cost of Funds index (11th District COFI), or the London Interbank Offering Rate (LIBOR). To compute the ARM interest level you take the index plus a margin established when the loan is first originated.
On the other hand, exactly one year ago this same index stood at 3.32%, so by adding the 2.75 percent margin your fully indexed rate would come to 6.07%, more than likely, a better option!
Adjustables can go up or down, but to prevent wild fluctuations most ARMs come with annual interest rate caps, lifetime interest caps, and monthly payment caps.
So what makes a hybrid attractive? The advantage is that start rates for hybrids are usually below fixed-rate mortgages.
A borrower can sometimes find a 5/1 ARM rate at up to a full percentage point below a comparable fixed rate loan, and for several years the homeowner will then reap the rewards of a lower rate. Generally, the shorter the fixed-rate period, the better the up-front discount, the longer the fixed-rate period, the smaller the discount when compared with 30-year fixed-rate financing.
But what happens after the fixed-rate period ends? Then you have an adjustable-rate mortgage -- unless you have already sold the home or refinanced the loan.
If you like the lower start rates of adjustable rate mortgages but don't like their inherent "swings" from one year to the next, think hybrid. It could be the best of both worlds.
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This loan program is an adjustable
rate mortgage with added flexibility of making one of several possible
payments on your mortgage every month, in order to better manage your
monthly cash flow.
It's low introductory start rate allows you to make very low initial mortgage payments and low qualifying rates enable you to qualify for more home. The minimum payment option can help keep your monthly payments affordable. If the minimum monthly payment is not sufficient to pay the monthly interest due, you can always avoid deferred interest by choosing the interest-only payment option. With the Option ARM, you generally have at least two fully amortized payment choices, leading to a quicker loan payoff. If you prefer to pay off your loan on schedule, you can make the fully amortized payment based on a 30-year loan, or you can choose the 15-year payment option for the fastest equity build-up. In most cases, you can also make additional principal payments which reduce the amount you need to pay in later months. Option ARM loan programs are right for you if you'd like to own your property only for a short time, and prefer affordability and flexibility in your monthly payment. However, if you select the minimum payment option in the early years, you should be prepared for possible sudden increases in your monthly payments thereafter. Option ARM loans have four major types of payment options:
These options should be clearly marked on your loan statement, so it is very easy to figure out how much you should pay each month. Just enter the correct amount in the payment coupon section of your statement. Option ARM loan programs are becoming more and more popular today, and there are many variations of this innovative home financing product on the market: Pay Option ARM, Pick-A-Payment Loan, 1 Month Option ARM, CashFlow Option Loan, LIBOR (or 12-MAT) Pay Option Loan, etc. If you are thinking about applying for an option ARM, it is important to shop carefully and investigate several loan products, to find the one best for you. Option ARM loan programs may vary in the initial rate, negative amortization and lifetime caps, ARM index, or optional features, however, when comparing one option ARM with another, pay close attention to the margin and the fully indexed rate. Keep in mind that the initial interest rate holds only for the 1st month. |
So there you have it. Remember, however, that there are many variations of monthly ARMs. If you like this kind of program, make sure you find one without points or a lengthy prepayment penalty. As I said, it's a complicated program -- make sure you understand it. And be aware that rates can rise.
Talk to Bruce Specter about this and other ARM programs.
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This page was last updated on 02/14/08.
