INDEX:
- Lenders generally use an index that
will be responsive to fluctuations in our economy - usually a one-year Treasury security
or the cost-of-funds index (COFI). The cost-of-funds index is more stable than
the Treasury index because it doesn't rise or fall as sharply over the long term
as the Treasury index.
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MARGIN:
The margin is the difference between
the index rate and the interest charged to the borrower. The margin doesn't
change throughout the loan term.
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"TEASER RATES"
A "teaser rate" is a reduced,
first-year introductory interest rate designed to attract borrowers to ARM's.
In the past, lenders were losing money on fixed-rate mortgages because these loans
were yielding less than the prevailing cost of money. Offering the adjustable-rate
mortgage allowed lenders to insulate themselves from these losses and increase earnings
by passing the risk of interest rate fluctuations on to the borrower. To make
the ARM attractive to borrowers, a low beginning interest rate was offered and through
time these introductory rates became known as "teaser rates". The
interest rate would then rise at each rate adjustment period until the rate equaled
the index rate + the margin. For example, let's say that the introductory rate
("teaser rate") for your adjustable-rate loan started at 4.5% interest
and would adjust upward 1.0% every six months. If your index for this loan
was 5.0% and the lenders margin was 3.0%, then the interest on your loan for the
first six months would be 4.5%. Six months later, it would increase to 5.5%
and so on until the fully-indexed rate was reached. To find the fully-indexed
rate, you would add the index to the margin (5.0% + 3.0%). After the fully-indexed
rate was reached, your loan would then fluctuate with the index on your loan.
If the index goes up or down, your payment would increase or decrease with the rise
or fall of the index on your adjustment period change date.
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RATE ADJUSTMENT
PERIOD:
The borrowers interest rates on an
adjustable-rate mortgage are allowed to be adjusted at certain intervals during the
loan term. Depending on the type of adjustable loan you have, this interval
could be six months, one year, three years or more.
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INTEREST RATE CAP:
There are limits on just how much
your payments can go up if you have an ARM. Usually these caps are in the form
of interest rate caps and/or payment caps. An interest rate cap determines
the maximum number of percentage points your interest can increase over the life
of the loan.
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MORTGAGE PAYMENT
ADJUSTMENT PERIOD:
The mortgage payment adjustment
period is the agreed upon intervals at which the payments of principal and interest
are changed. The lender can either adjust the rate periodically and adjust
the mortgage payment to reflect the change, or the lender can adjust the rate more
frequently than the mortgage payment is adjusted. For example, the loan agreement
may call for the interest to be adjusted every six months, but the payment to be
adjusted every three years. This scenario could be a problem. If in the
interim between payment periods (3 years), interest rates have gone up or down too
much, there will have been too much or too little interest paid on the loan by the
borrower over that period of time, and the difference will be added to or subtracted
from the loan balance. When unpaid interest is added to the loan balance, it
is called negative amortization.
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MORTGAGE PAYMENT
CAP:
A mortgage payment cap is the maximum
allowable interest rate the lender can charge on your loan regardless of what happens
in the market. Depending on your particular loan program, this is a percentage
(usually 5% to 7.5% annually) that can be added to your fully indexed rate if the
market warrants moving that high. For example, if your fully indexed rate is
8% and your annual cap is 6%, your loans life cap would be 14%.
Mortgage payment caps were designed
to limit unrestricted increases by lenders and keep the borrowers payments at a manageable
level. Some lenders impose payment caps, some impose interest rate caps and
some lenders use both.
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NEGATIVE AMORTIZATION
CAP:
A negative amortization cap limits
the amount of negative amortization that can be reached on a loan. When the
cap is reached, the loan is re-amortized to a level sufficient to pay off the loan
over the remaining term of the loan.
CONVERSION OPTION:
A conversion option on an adjustable
rate mortgage is called a Convertible ARM. A conversion option gives the borrower
the option to convert their adjustable-rate mortgage to a fixed-rate loan.
Convertible Arm's normally have a higher initial interest rate (even the converted
fixed rate will usually be higher). You will usually have a time frame in which
to convert the loan to a fixed rate. For example, you might have to make your
decision to convert the loan sometime after the first year and before the fifth year
ends. In most cases, there is also a conversion fee imposed on the borrower
(for instance 1% of the total loan amount).
There are many different ARM programs to choose from with many available options.
If you are considering an adjustable-rate mortgage, we will be happy to explain your
options to you and make sure you have the right program to meet your needs.
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