Adjustable Rate Mortgage

The adjustable rate mortgage (ARM) is worth more than one post.  I last wrote that its great draw—a low initial interest rate—can be worked to a homebuyer’s advantage,  But, I spent more time explaining how the interest rate, being variable, can also be a pitfall.

There are some other features about this type of loan that have a double-edge.

You often hear an ARM called an option mortgage.  The option refers to the type of monthly payment you choose.  Lenders will offer several choices:

1)      Interest only

2)      Minimum payment

3)      Fully amortized

Only the fully amortized option (usually set up for 30 or 15 years) is designed for you to actually pay off the principal of the loan.  (Amortization is the gradual paying off a loan over a scheduled period of time.)  This involves paying back a designated portion of your principal along with all interest accrued each month.  (Paying against the loan principle gives you value—equity—in your property.)  Payment amounts will vary according to your current interest rate.  Also, if you opt (often or even occasionally) to use either of the other payment methods, the amount you pay against the principal will have to be refigured to keep your payoff on schedule.

—Yes, with this type of mortgage you can change your payment type from month to month.  But, the consequence of regularly using the interest only and the minimum payment options of an adjustable rate mortgage is that little or no equity is accrued and negative amortization is possible.  (Negative amortization is an increase in the unpaid balance of loan principal.  This contrasts with equity, which is an increase in the value you actually hold in your property as you pay off the principal. )

Consider:

1)   If interest only payments are made, nothing happens to diminish the principal.    

If this is your practice for the life of the loan, the whole of the principal will be due at the end.

2)   A minimum monthly payment is set in the mortgage contract.  Given that the  

      interest rate will vary, it’s quite likely that making minimum payments will

      not cover the interest owed at any current time, much less reduce the

      principal.  When this happens the monthly excess is added to the principal.  At

      the conclusion of the contract you could owe more money than you originally

      borrowed.

Lenders see a risk of not recouping principal in both these scenarios.  Limits may be set as to how long into the life of the loan these options are available.  However, if you—the borrower—choose to use these payment options, you need to be financially prepared at some point in time to assume fully amortized payments or to make what could be an extremely large payment at the end your contract (a balloon payment).

Paying off a mortgage is a long-term endeavor.  During that time, the status of both your personal finances and the general economy can fluctuate.  Most people, being familiar with charges that are fairly uniform, adjust their whole lifestyle to accommodate financial cycles and continue making payments.  An ARM may allow a homebuyer the luxury downsizing what is likely to be his largest payment—the house payment.  Frequent use of the interest only or minimum payment options can mask serious, deteriorating financial issues that will have to be addressed before the end of the mortgage contract.

The variable (and likely, rising) interest rate of an ARM along with the payment options feature can add to the challenge of successfully buying a house.  However, if you buy property with the intent of a quick resale (and therefore, are unlikely to be long in the mortgage contract) or are familiar and comfortable with large fluctuations in your income that will allow you to make an occasional large payment against the principal, an adjustable rate mortgage (an option mortgage) might be viable.

Adjustable Rate Mortgage Buying a House

The cost of repaying an adjustable rate mortgage (ARM) changes over the life of the loan.  As a potential home buyer you may favorably view acquiring this type of loan when interest rates are low.  If you have ARM financing, your initial payment terms tend to be very good.  However, your lending institution intends to make a profit before the principle (money borrowed) is repaid.  That profit comes from charging interest on the principle.  With an ARM your lender anticipates increasing the interest earnings over the life of the loan.

The interest rate isn’t arbitrary.

It’s tied to an index.  An index is an interest rate related to the cost of doing business at high financial levels—like the Prime Rate (which is the interest rate banks charge other banks when they lend them money).  However, for an ARM the Cost of Savings Index or the 1 Year Treasury Index are among the indexes more likely to be considered.

 Index rates fluctuate, so they are usually quoted at a periodic average.  The index used can be a 2, a 3, a 6.5—any percentage; it is determined by the process of money making money.

Your lender will add a margin to the index used.  (Margin means additional interest points.  There are 100 points per one percent.)  Basically, the margin insures the lender of making some profit, so your credit worthiness is influential in determining it.  The more risk the lender perceives in recouping the loan principle, the higher the margin will be.

Say the index your lender is using when you apply for an adjustable rate mortgage is at 3.75 and you are assigned a margin of 2 percent: This means the initial interest rate on your loan would be 5.75 percent. 

I’ve mentioned an initial period or initial interest rate a couple of times.  That’s because the interest rate on this type of mortgage is set up for periodic change.  That variability occurs in the index rate.  The margin, however, is constant for the duration of the loan.

The initial rate period is a significant issue.  Depending on your loan agreement, it can last one month or up to several years.  Your interest rate is fixed for this period and (often) is the lowest it will ever be.  Sometimes a lender will even give you a discounted rate for this period.  But, watch out!  A ridiculously low initial rate might be followed by a really large increase built into the first adjustment; it’s also possible for your lender to recoup funds through high closing costs.

After the initial payment period the interest will be adjusted at predetermined intervals to reflect (then) current rate of the index to which it is tied.  (An exception to this could be the first adjustment.  The rate for that one is, sometimes, determined as a separate item in the loan agreement.) Subsequent adjustments will be made on a regular schedule—monthly, quarterly, semi-yearly, yearly, or every x-number of years— according to your loan agreement. 

Since it is impossible to predict what an index will do over a number of years, your adjustments may result in increased or decreased interest rates.  Adjustable rate mortgages are typically written for 15 or 30 years.  Within those blocks of time there could be several economic booms or busts—trends that influence index rates.  Indexes could vary significantly from period to period.  For protection against extreme interest rate increases, insist on rate caps (periodic and overall) in your contract.

Some indexes do not allow for rate caps.  You risk exorbitant interest increases if your loan is tied to one of these. 

You can be sure your lender will want to include a floor. The floor is the lowest rate to which your interest will be allowed to fall.  (This is, really, another type of cap—one that favors the lender.)

Another protective measure on your part would be to include a conversion clause.  This clause allows you to change your adjustable rate mortgage into a fixed rate mortgage.  Its terms can be negotiated.

The unpredictability of indexes and therefore of your interest rate is the great risk in taking this type of loan.  The great advantage of an adjustable rate mortgage is its low initial interest rate.  As you begin to repay the loan, your interest payments will be much lower than any associated with a fully fixed rate.

This benefit can often be utilized by taking a long-term loan. (If your financial profile is good, that can help in securing a lower margin.)  Negotiate the longest initial rate period you can.  Then, pay off the loan very early.  This requires you to plan ahead and arrange the financial resources to accomplish your purpose.  (Of course, lenders are familiar with this strategy and may try to incorporate a penalty fee for early payoff.  —It’s up to you to calculate and defend your advantage in any contract.)

Remember:  When buying a house, you can shop for a loan—the same way you would shop for any other commodity.  Do some product research.  Then, check out several lenders, and compare available terms before applying for an adjustable rate mortgage.