Adjustable Rate Mortgages (ARMs)
ARMs offer borrower's two major benefits, First, if interest rates remain fixed or move lower, the adjustable rate loan could prove more economical for the borrower in the long-run. Second, lenders usually charge a discounted rate, which lowers the initial interest rate on the adjustable loan. Since the amount of the loan is determined on current income and first year payments, many borrowers can qualify for a larger loan.
There are also disadvantages to ARMs. Borrowers assume the risk of potential interest rate increases and higher monthly mortgage payments. ARMs, because of their nature, are occasionally subject to Negative Amortization., a situation where the limits on the monthly payment increases can prevent the mortgage payments from totally paying the monthly interest costs of the loan. In that situation, unpaid interest is added to the unpaid principal balance! With most mortgages, each payment will decrease the principal balance, eventually paying off the loan. In a situation of Negative Amortization, the unpaid principal balance actually increases, rather than continuing to decrease.
There are several key elements which affect and impact the functioning of the ARM.
Adjustment Period. Interest rate changes, and the corresponding changes to the mortgage payment, occur on a specific schedule as detailed in the original loan agreement. The period of time between one interest rate change and the next is called the Adjustment Period. These Adjustment Periods can occur every 6 months, every year, every two years, every three years, or every five years. However, over 60% of all ARMs feature annual adjustments to the interest rate.
Indexes. The index, as mentioned earlier, is selected to reflect changes in the general movement of interest rates. The function of the index is to keep the interest rate on the loan consistent with the interest rate fluctuations in the economy, thereby, assuring the lender long term profitability.
The index is probably the most important factor in Adjustable Rate Mortgages. Usually, any errors or mistakes in calculating and implementing an Interest Rate Change can be traced back to the selection of the index. That fact shouldn't be surprising, once you have the opportunity to review some of the index information below. Individual indexes can feature a variety of maturity periods and frequently, some indexes are commonly referred to by a variety of slightly differing names.
U.S. Treasury Bills, monthly auction averages
U.S. Treasury Bills, weekly auction averages
U.S. Treasury Securities, monthly constant maturity rates
U.S. Treasury Securities, weekly constant maturity rates
National Average Contract Mortgage Rate (NACMR) For the Purchase of Previously Occupied Homes by Combined Lenders
Eleventh District Cost of Funds (11COF)
There are other elements which are involved in ARM adjustments.
The look-up-date is the exact date which the lender uses to determine the new index value when calculating a new interest rate for an ARM. The actual procedures for determining this date should be specified in the original loan agreement. This may initially seem a rather trivial consideration, however, when some indexes are published on a weekly basis, there is the possibility that a variation of even one day could change the index value, which in turn significantly changes the interest rate calculated.
Rounding the New Interest Rate
Many ARMs also feature provisions for the procedures to be used in rounding the New Interest Rate. There are two types of rounding procedures used most commonly.
Rounding TO THE NEAREST one-eighth of one percent, which could either be a lower or a higher value.
Rounding UP TO THE NEAREST one-eighth of one percent, which is always rounded to a higher value.
Interest Rate Caps
Caps are frequently used in ARMs to prevent the interest rate on the loan from rising or falling too dramatically, either during the course of a single adjustment, or over the full term or life of the loan. Caps work to the advantage of both the borrower and the lender. There are two basic types of caps-Life (or Overall) Caps and Per Adjustment (or Periodic) Caps.
Life/Overall Caps. This type of cap places specific limits on the range of the interest rate during the term of the loan. These caps can provide for either a maximum interest rate, a minimum interest rate, or both. By law, virtually all ARMs must have some type of Life/Overall Cap. A Life/Overall Cap will be stated in the original loan document.
Per Adjustment/Periodic Caps. This type of cap places specific limits on the interest rate changes during the course of each Adjustment. These caps save the borrower from "Payment Shock", or very dramatic increases in the Mortgage Payment during a single Adjustment. This type of cap may also have either a minimum value, a maximum value, or both. A Per Adjustment/Periodic Cap will be stated in the original loan document.
Payment Caps restrict the size of the increase in the monthly payment at each adjustment and are usually expressed as a percentage of the previous payment amount. Any applicable Payment Cap for the loan will be specifically stated in the original loan agreement.
To summarize the above parameters regarding ARMs,
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