Fixed Rate Loans
A fixed rate loan has an interest rate that stays the same during the term of the loan. This means that your loan payments are set from the initial amortization, or repayment, schedule. The clear benefit of a fixed rate loan is that is offers stability in fluctuating market conditions.
Hybrid Loans
Commonly known as 3/1’s, 5/1’s, 7/1’s and 10/1’s or 3 year fixed, 5 year fixed loans, ext; these loans are impart a fixed loan coupled with an adjustable loan that usually provide a lower rate and payment of interest over that of the fixed rate loan. See previous pages for examples.
Adjustable Rate Mortgages
Adjustable rate mortgages (Arm’s) are home loans with interest rate that change periodically. They may have lower initial rate for a short time at the beginning of the term. After that, the interest rate used to calculate repayment is adjustable on a regular basis. Since the monthly payments may go up or down with changes in interest rates, the future monthly loan payments may be uncertain. Arm’s carry risks in periods of rising interest rates, but can be less costly over the life of the loan if the average interest rate is below the fixed rate.
Some important components of Arm’s include:
- The Index
- The Margin
- Periodic and Lifetime Caps
- Rate and Payment Adjustments
- Deferred Interest (negative amortization)
How do Arm’s Work?
Lenders usually charge lower initial interest rates for ARMs than for fixed rate loans because the borrower is sharing the risk if interest rate goes up. Arms therefore are less expensive in the beginning than fixed rate loans. This may mean that a borrower can qualify for a larger loan if they select an ARM. The risk here is that if rate rise substantially, the payments can become prohibitive.
Indexes
Arm’s interest rate changes are tied to changes in an index rate. An index usually moves with the general trend of the economy. The most commonly used indices are listed below:
Six-Month Certificate of Deposit (6 month CD):
This index is the weekly average of the secondary market interest rate paid on Bank’s Six-Month CDs. This index is generally considered to react quickly to changes in the market.
One Year Treasury (1 Year T-Bill):
This is the weekly average yield on the U.S. Treasury Securities adjusted to a constant maturity of one year. This index generally reacts quickly to market changes.
11th District Cost of Funds Index (COFI):
The average cost of deposits and borrowings for Savings & Loans in the Federal Home Loan Bank’s 11th District, which consists of California, Arizona, and Nevada. This index is slow moving due to the size of the deposits (approx. $3.5 Billion) and generally lags behind market fluctuations.
London InterBank Offered Rate (LIBOR):
The LIBOR is an average of the daily lending rates from several major English banks, used as a common international interest rate index. Like the CD, it tends to react quickly to changes in the market.
Prime Rate
The Prime is the lowest commercial rate charged by banks on short-term loans to their most credit worthy customers. Mortgage rates and consumer loans rates are generally close to the prime rate, but exceptions occur.
Margin
To establish the ARM rate, percentage points are added to the index value. These percentage points are called the margin. The margin is established by the lender at the inception of the loan and remains constant for the term of the loan. To calculate the interest rate at the time of adjustment, the new rate is the index plus the margin (Rate=Index+Margin). The ARM interest rate will move as close to this new value as the period caps permit.
Periodic & Lifetime Caps
When an adjustable rate loan is established, in the note a schedule is broken out for the frequency of adjustment. A typical example would be one year ARM based on the One Year Treasury Spot. The loan would have a low start rate, and after the 12th month, it would adjust, and would continue to adjust annually for the term of the loan. ARMs are usually named for the frequency of the rate and payment adjustments. A loan that adjusts annually with the rate based on the One Year Treasury Spot is called a 1 Year T-Bill.
To make ARMs an attractive alternative to fixed rates, caps of limitations are built in so that then adjustment cannot be too severe. For example, on the 1 Year T-Bill, usually there is a 2.00% annual cap. This means that to calculate the rate for month 13 (Rate=Index + Margin), the lender will look at the fully indexed rate and adjust the new rate as close to this as the cap will permit. For example, if the loan started at 5.00% and had a 2.00% annual cap, the maximum rate for the second year would be 7.00% and the maximum for the third year would be 9.00% regardless of what Index + Margin is.
In addition to these periodic carps, ARMs will also contain a lifetime cap of ceiling. That is the maximum rate for the life of the loan, regardless of what market dictates. This amount can be considered the “worst case” interest rate and will usually exceed current fixed interest rates.
Payment Caps and Deferred Interest (Negative Amortization)
In addition to periodic caps there are payment caps. This is a fine but important distinction. These loans will not have a built in periodic cap, usually just a lifetime cap. What they offer is a payment cap. This is a maximum that the minimum payment can change in any given period. The lender is still calculating the rate on Index + Margin, but they offer a minimum payment which may be less than this fully indexed rate. The difference in the payment is called deferred interest.
Annually the loan will be reviewed to determine how short the minimum payments were compared to the fully indexed rate. This difference is then added to the loan balance, hence the term negative amortization.
The way to avoid this is to not make the minimum payment, but to make the fully indexed payment. Cost of Funds (COFI) loans are usually structured this way.
11th District Cost of Funds ARM and Monthly Treasury Index (COFI/MTA)
The “dinosaur” of the adjustable market, the COFI is the slowest moving adjustable index offered. The MTA is also a slow moving index and used by some lenders instead of the COFI. Typically used for purchases, these programs will provide the most stable adjustable payments over any other adjustable loan index while providing monthly payment options.
These options include:
1. Principal and Interest payments over 30 Years 2. Principal and Interest payments over 15 years 3. Interest Only Payments 4. Minimum of Deferred Interest Payment (calculated by Lender each Month after the first year).
80/10/10 and 80/15/5 Financing
The above programs provide one of the best ways to remove mortgage insurance on purchases when the borrower can only place 5% or 10% down. Basically what happens is the loan agent (typically a mortgage broker only) obtains two forms of finance, a first mortgage and a second mortgage. This first mortgage is for 80% of the property while the second mortgage is for 10% for 80/10/10’s or 15% for 80/15/5’s. The remainder of the down comes from the borrower. This type of financing accomplishes several tasks: 1. It removes mortgage insurance (MI)
2. It provides the borrower an increased interest write-off not found with MI
3. Lastly, it allows more options on refinancing in the future with a greater selection to lenders.
LOAN OPTIONS
30 Year Fixed: Fixed for the entire 30 year term of the loan. This is the most conservative mortgage available providing absolute rate stability but most likely a substantially higher rate than ARM’s or hybrids such as the five year or three year mortgages. This loan does not have a prepayment penalty and does not have negative amortization.
15 Year Fixed: Fixed for the entire 15 year term of the loan. This is the most conservative mortgage available providing absolute rate stability but most likely a substantially higher rate than ARM’s or hybrids such as the five year or three year mortgages. This loan provides a substantially higher payment than the 30 year fixed but pays off in half the time. Significantly less interest will be paid over time. However, securing a 30 year fixed and investing the payment difference elsewhere (e.g. stock or Ira) might be a wiser investment decision (see your financial adviser). This loan does not have a prepayment penalty and does not have negative amortization.
10 Year ARM Hybrid: Fixed at the initial rate for ten years. After the 120th month the loan will adjust each adjustment period to the lower of: 1) the current index plus the margin, 2) the previous rate plus the periodic cap, or 3) the life time cap. Depending on the recommended product for the day, this mortgage may have a first time adjustment higher than the periodic cap. This is a fully amortizing loan with a term of 30 years. The loan does not have a prepayment penalty and does not have negative amortization.
7 Year ARM Hybrid: Fixed at the initial rate for seven years. After the 84th month the loan will adjust each adjustment period to the lower of: 1) the current index plus the margin, 2) the previous rate plus the periodic car, or 3) the life time cap. Depending on the recommended product for the day, this mortgage may have a first time adjustment higher than the periodic cap. This is a fully amortizing loan with a term of 30 years. The loan does not have a prepayment penalty and does not have negative amortization.
5 Year ARM Hybrid: Fixed at the initial rate for five years. After the 60th month the loan will adjust each adjustment period to the lower of: 1) the current index plus the margin, 2) the previous rate plus the periodic car, or 3) the life time cap. Depending on the recommended product for the day, this mortgage may have a first time adjustment higher than the periodic cap. This is a fully amortizing loan with a term of 30 years. The loan does not have a prepayment penalty and does not have negative amortization.
3 Year ARM Hybrid: Fixed at the initial rate for three years. After the 36th month the loan will adjust each adjustment period to the lower of: 1) the current index plus the margin, 2) the previous rate plus the periodic car, or 3) the life time cap. Depending on the recommended product for the day, this mortgage may have a first time adjustment higher than the periodic cap. This is a fully amortizing loan with a term of 30 years. The loan does not have a prepayment penalty and does not have negative amortization.
1 Year ARM (includes 1 Year T-Bill, 1 Year T-average and 1 Year T-Spot): Fixed at the initial rate for one year. Thereafter, it will adjust each 12 months over a 30 year term to the lower of: 1) the current index plus the margin, 2) the previous rate plus the periodic car, or 3) the life time cap. Depending on the recommended product for the day, this mortgage may have a first time adjustment higher than the periodic cap. This is a fully amortizing loan with a term of 30 years. The loan does not have a prepayment penalty and does not have negative amortization. |
