Understanding
Loan Programs
Fixed Rate Mortgages
The most common type of mortgage program where your monthly
payments for interest and principal never change. Property taxes and homeowners insurance
may increase, but generally your monthly payments will be very stable.
Fixed-rate mortgages are available for 30 years, 20 years,
15 years and even 10 years. There are also "bi-weekly" mortgages, which shorten
the loan by calling for half the monthly payment every two weeks. (Since there are 52
weeks in a year, you make 26 payments, or 13 "months" worth, every year.)
Fixed rate fully amortizing loans have two distinct
features. First, the interest rate remains fixed for the life of the loan. Secondly, the
payments remain level for the life of the loan and are structured to repay the loan at the
end of the loan term. The most common fixed rate loans are 15 year and 30 year mortgages.
During the early amortization period, a large percentage of
the monthly payment is used for paying the interest . As the loan is paid down, more of
the monthly payment is applied to principal . A typical 30 year fixed rate mortgage takes
22.5 years of level payments to pay half of the original loan amount.
Adjustable Rate Mortgages
These loans generally begin with an interest rate that is
2-3 percent below a comparable fixed rate mortgage, and could allow you to buy a more
expensive home.
However, the interest rate changes at specified intervals
(for example, every year) depending on changing market conditions; if interest rates go
up, your monthly mortgage payment will go up, too. However, if rates go down, your
mortgage payment will drop also.
There are also mortgages that combine aspects of fixed and
adjustable rate mortgages - starting at a low fixed-rate for seven to ten years, for
example, then adjusting to market conditions. Ask your mortgage professional about these
and other special kinds of mortgages that fit your specific financial situation
Introductory Rate ARM's
Most adjustable rate loans (ARMs) have a low introductory
rate or start rate, some times as much as 5.0% below the current market rate of a fixed
loan. This start rate is usually good from 1 month to as long as 10 years. As a rule the
lower the start rate the shorter the time before the loan makes its first adjustment.
Index - The index of
an ARM is the financial instrument that the loan is "tied" to, or adjusted to.
The most common indices, or, indexes are the 1-Year Treasury Security, LIBOR (London
Interbank Offered Rate), Prime, 6-Month Certificate of Deposit (CD) and the 11th District
Cost of Funds (COFI). Each of these indices move up or down based on conditions of the
financial markets.
Margin - The margin is
one of the most important aspects of ARMs because it is added to the index to determine
the interest rate that you pay. The margin added to the index is known as the fully
indexed rate. As an example if the current index value is 5.50% and your loan has a margin
of 2.5%, your fully indexed rate is 8.00%. Margins on loans range from 1.75% to 3.5%
depending on the index and the amount financed in relation to the property value.
Interim Caps - All
adjustable rate loans carry interim caps. Many ARMs have interest rate caps of six-months
or a year. There are loans that have interest rate caps of three years. Interest rate caps
are beneficial in rising interest rate markets, but can also keep your interest rate
higher than the fully indexed rate if rates are falling rapidly.
Payment Caps - Some
loans have payment caps instead of interest rate caps. These loans reduce payment shock in
a rising interest rate market, but can also lead to deferred interest or "negative
amortization". These loans generally cap your annual payment increases to 7.5% of the
previous payment.
Lifetime Caps - Almost
all ARMs have a maximum interest rate or lifetime interest rate cap. The lifetime cap
varies from company to company and loan to loan. Loans with low lifetime caps usually have
higher margins, and the reverse is also true. Those loans that carry low margins often
have higher lifetime caps.
Standard ARM Programs
A few options are available to fit your individual needs
and your risk tolerance with the various market instruments.
ARMs with different indexes are available for both
purchases and refinances. Choosing an ARM with an index that reacts quickly lets you take
full advantage of falling interest rates. An index that lags behind the market lets you
take advantage of lower rates after market rates have started to adjust upward.
The interest rate and monthly payment can change based on
adjustments to the index rate.
6-Month Certificate of
Deposit (CD) ARM
Has a maximum interest rate adjustment of 1% every six months. The 6-month Certificate of
Deposit (CD) index is generally considered to react quickly to changes in the market.
1-Year Treasury Spot ARM
Has a maximum interest rate adjustment of 2% every 12 months. The 1-Year Treasury Spot
index generally reacts more slowly than the CD index, but more quickly than the Treasury
Average index.
6-Month Treasury Average ARM
Has a maximum interest rate adjustment of 1% every six months. The Treasury Average index
generally reacts more slowly in fluctuating markets so adjustments in the ARM interest
rate will lag behind some other market indicators.
12-Month Treasury Average ARM
Has a maximum interest rate adjustment of 2% every 12 months. The treasury Average index
generally reacts more slowly in fluctuating markets so adjustments in the ARM interest
rate will lag behind some other market indicators.
LIBOR - London InterBank Offered Rate
LIBOR is the rate on dollar-denominated deposits, also know
as Eurodollars, traded between banks in London. The index is quoted for one month, three
months, six months as well as one-year periods.
LIBOR is the base interest rate paid on deposits between
banks in the Eurodollar market. A Eurodollar is a dollar deposited in a bank in a country
where the currency is not the dollar. The Eurodollar market has been around for over 40
years and is a major component of the International financial market. London is the center
of the Euromarket in terms of volume.
The LIBOR rate quoted in the Wall Street Journal is an
average of rate quotes from five major banks. Bank of America, Barclays, Bank of Tokyo,
Deutsche Bank and Swiss Bank.
The most common quote for mortgages is the 6-month quote.
LIBOR's cost of money is a widely monitored international interest rate indicator. LIBOR
is currently being used by both Fannie Mae and Freddie Mac as an index on the loans they
purchase.
LIBOR is quoted daily in the Wall Street Journal's Money
Rates and compares most closely to the 1-Year Treasury Security index.
Balloon Mortgages
Balloon loans are short term mortgages that have some
features of a fixed rate mortgage. The loans provide a level payment feature during the
term of the loan, but as opposed to the 30 year fixed rate mortgage, balloon loans do not
fully amortize over the original term. Balloon loans can have many types of maturities,
but most balloons that are first mortgages have a term of 5 to 7 years.
At the end of the loan term there is still a remaining
principal loan balance and the mortgage company generally requires that the loan be paid
in full, which can be accomplished by refinancing. Many companies have other options such
as a conversion feature at the end of the term. For example, the loan may convert to a 30
year fixed loan at the thirty year market rate plus 3/8 of a percentage point. Your
conversion can be guaranteed based on certain criteria such as having made your last 24
payments on time. The balloon mortgage program with the conversion option is often called
a 7/23 Convertible or 5/25 Convertible.
Buydown Options
The most common buydown is the 2-1 buydown. In the past,
for a buyer to secure a 2-1 buydown they would pay 3 points above current market points in
order to pay a below market interest rate during the first two years of the loan. At the
end of the two years they would then pay the old market rate for the remaining term.
As an example, if the current market rate for a conforming
fixed rate loan is 8.5% at a cost of 1.5 points, the buydown gives the borrower a first
year rate of 6.50%, a second year rate of 7.50% and a third through 30th year rate of
8.50% and the cost would be 4.5 points. Buydown were usually paid for by a transferring
company because of the high points associated with them.
In today's market, mortgage companies have designed
variations of the old buydowns rather than charge higher points to the buyer in the
beginning they increase the note rate to cover their yields in the later years.
As an example, if the current rate for a conforming fixed
rate loan is 8.50% at a cost of 1.5 points, the buydown would give the buyer a first year
rate of 7.25%, a second year rate of 8.25% and a third through 30th year rate of 9.25% ,
or a three-quarter point higher note rate than the current market and the cost would
remain at 1.5 points.
Another common buydown is the 3-2-1 buydown which works
much in the same ways as the 2-1 buydown, with the exception of the starting interest rate
being 3% below the note rate. Another variation is the flex-fixed buydown programs that
increase at six month interval rather than annual intervals.
As an example, for a flex-fixed jumbo buydown at a cost of
1.5 points, the first six months rate would be 7.50%, the second six months the rate would
be 8.00%, the next six months rate would be 8.50%, the next six months rate would be
9.00%, the next six months the rate would be 9.50% and at the 37th month the rate would
reach the note rate of 9.875% and would remain there for the remainder of the term. A
comparable jumbo 30 year fixed at 1.5 points would be 8.875%.
COFI ARM Cost of Funds Index
The 11th District Cost of Funds is more prevalent in the
West and the 1-Year Treasury Security is more prevalent in the East. Buyers prefer the
slowly moving 11th District Cost of Funds and investors prefer the 1-Year Treasury
Security.
The monthly weighted average Eleventh District has been
published by the Federal Home Loan Bank
of San Francisco since August 1981. Currently more than one half of the savings
institutions loans made in California are tied to the 11th District Cost of Funds (COF)
index.
The Federal Home Loan Bank's 11th District is comprised of
saving institutions in Arizona, California and Nevada.
Few people who use and follow the 11th District Cost of
Funds understand exactly how it is calculated, what it represents, how it moves and what
factors affect it.
The predecessor to the 11th District Cost of Funds index
was the District semiannual weighted average cost of funds published for a six month
period ending in June and December. The San Francisco Bank was the first Federal Home Loan
Bank to publish a monthly cost of funds index.
The funds used as a basis for the calculation of the 11th
District Cost of Funds index are the liabilities at the District savings institutions:
money on deposit at the institutions, money borrowed from a Federal Home Loan Bank (known
as advances) and all other money borrowed. The interest paid on these types of funds is
the cost of these funds.
The ratio of the dollar amount paid in interest during the
month to the average dollar amount of the funds for that month constitutes the weighted
average cost of funds ratio for that month.
The average cost of funds is said to be weighted because
the three kinds of funds and their costs are added together before a ratio is computed
rather than calculating averages individually for the three sources and using a simple
average of the three ratios. This gives the greatest weight to the interest paid on
deposits, and explains the delayed reaction of the index to rising fixed-rate mortgages.
GPM Graduated Payment Mortgage
The GPM is another alternative to the conventional
adjustable rate mortgage, and is making a comeback as borrowers and mortgage companies
seek alternatives to assist in qualify for home financing
Unlike an ARM, GPMs have a fixed note rate and payment
schedule. With a GPM the payments are usually fixed for one year at a time. Each year for
five years the payments graduate at 7.5% - 12.5% of the previous years payment.
GPMs are available in 30 year and 15 year amortization, and
for both conforming and jumbo loans. With the graduated payments and a fixed note rate,
GPMs have scheduled negative amortization of approximately 10% - 12% of the loan amount
depending on the note rate. The higher the note rate the larger degree of negative
amortization. This compares to the possible negative amortization of a monthly adjusting
ARM of 10% of the loan amount. Both loans give the consumer the ability to pay the
additional principal and avoid the negative amortization. In contrast, the GPM has a fixed
payment schedule so the additional principal payments reduce the term of the loan. The
ARMs additional payments avoid the negative amortization and the payments decrease while
the term of the loan remains constant.
The scheduled negative amortization on a GPM differs
depending on the amortization schedule, the note rate and the payment increases of the
loan. GPM loans with 7.5% annual payment increases offer the lowest qualifying rate but
the largest amount of negative amortization.
On a loan of $150,000, with a 30 year amortization and a
note rate of 10.50% with 12.5% annual payment increases, the negative amortization
continues for 60 months. The qualifying rate is 5.75% and the negative amortization is
11.34% (approximately $17,010).
The note rate of a GPM is traditionally .5% to .75% higher
than the note rate of a straight fixed rate mortgage. The higher note rate and scheduled
negative amortization of the GPM makes the cost of the mortgage more expensive to the
borrower in the long run. In addition, the borrowers monthly payment can increase by as
much as 50% by the final payment adjustment.
The lower qualifying rate of the GPM can help borrowers
maximize their purchasing power, and can be useful in a market with rapid appreciation. In
markets where appreciation is moderate, and a borrower needs to move during the scheduled
negative amortization period they could create an unpleasant situation.
Choosing A Mortgage Program
There isn't a single or simple answer to this question. The
right type of mortgage for you depends on many different factors:
- Your current financial picture.
- How you expect your finances to change.
- How long you intend to keep your house.
- How comfortable you are with your mortgage payment changing.
For example, a 15-year fixed-rate mortgage can save you
many thousands of dollars in interest payments over the life of the loan, but your monthly
payments will be higher. An adjustable rate mortgage may get you started with a lower
monthly payment than a fixed-rate mortgage -- but your payments could get higher when the
interest rate changes.
The best way to find the "right" answer is to
discuss your finances, your plans and financial prospects, and your preferences frankly
with a mortgage professional.
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