Adjustment Period. The adjustment of an
ARM loan is the period of time between one interest rate and monthly
payment change and the next. Some ARM loan have two adjustments, one for
the rate, second for the payment. The period is different for each ARM; it
may occur once a month, every six months, once a year, or every three
years. A loan with an adjustment period of one year is called a one-year
ARM, and the interest rate can change once each year. Lenders often have a
longer adjustment periods. Because lenders might offer four different
types of ARMs, each with a different adjustment period, it is important
for the borrower to read the loan documents and understand the adjustment
period before the loan documents are cut or signed.
Index and Margin. Most lenders tie ARM interest rate changes to change of
an index rate. The only requirements a lender
must meet in selecting an interest index are:
-the index control cannot be the lender and
-the index
must be readily available to and verifiable by the public.
These indexes usually go up and down with the general
movement of interest rates. If the index moves up, so does the interest
rate on the loan, meaning the borrower will make higher monthly payments.
On the other hand, if interest rate goes down, so the monthly payment.
Lender base ARM rates on a variety of indexes, in fact the
index can be almost any index lender selects. Among the most common
indexes are 6 month, 3 year or 5 yeear Treasury Securities , T-Bills.;
national or regional cost of funds (11th district COFI) and the London
InterBank Offering Rate (LIBOR)
To determine interest rate on an ARM, lenders add to the
index rate a few percentage points (2 or3), called the margin (also
differential or spread)
ARM Rate = Index Rate + Margin
The amount of margin can differ from lender to another, but
is always constant over the life of the loan, Loans that have lower loan
origination costs tend to have higher margins. Upward adjustments of the
ARM interest rate are made at the lender's optio, but downward adjustments
are mandatory. On each loan the borrower's terms; including initial rate,
caps, index, margin, interest rate change frequency and the payment change
frequency, are stated in the same note that accompanies the deed of trust.
Terms vary from lender to lender.
ARM Discounts. Some lenders offer initial
ARM rates that are lower than the sum of the index and the margin. Such
rates, called discounted rate, introductory rates, tickler rates or teaser
rates, are usually combined with loan fees (points) and with higher
interest rates after the discount expires. Many lenders currently offer
introductory rates that are significantly below market interest rates. The
discount rates may expire after the first adjustment period (for example
after 1 month, 6 months or 1 year). At the end of the introductory
discount rate period the ARM interest rate automatically increases to the
contract interest rate (index + margin). This can have a substantial
increase in the borrower's interest rate and payment. If the index
rate has moved upward, the interest rate and the payment adjustment can be
even higher. Even if the index rate has decreased, the borrower's interest
rate and monthly payment will likely be adjusted upward at the end of the
introductory period.
Many lender use the first year\s payment
as the basis for qualifying a borrower for a loan. So even if a lender
approves the
loan,
based on the low introductory rate, it is the borrower's responsibility to
determine whether he or she will be able to afford payment is later years,
when the discount expires and the rate is adjusted. In fact, this kind of
loan subjects the borrower to greater risk, including that of payment
shock, which may occur when the payment rises at the first adjustment.
Caps on ARM. Most ARM's have caps that
protect borrower from increases in interest rates or monthly payments
beyond an amount specified in the note. If loans have no payment cap,
borrower might be exposed to unlimited upward adjustments in monthly
payments should interest rate rise. Some lenders also allow borrowers to
convert an ARM to a fixed rate loan.
Caps vary from lender to lender. The most common are:
A periodic cap: limits the interest rate increase or
decrease from one adjustment period to the next. These caps are usually 1%
point to 2% point to sometimes 7.5% point of the previous payment
amount.
A lifetime cap or overall cap limits the interest rate
increase over life of the loan. Assume the introductory rate is 6%, and
the first adjustment rate becomes 8%. The overall cap will be attached to
the 8%, thus, a 5% cap could mean an interest rate as high as 13%.
An ARM usually has both a periodic and an overall interest
rate cap. Some ARMs that have interest rate caps, the monthly payments may
increase, even though the index rate has stayed the same or declined.
Because payment caps limit only the amount of payment
increases and not interest rate increases, payments sometimes do not cover
all of the interest due on a loan. Sometimes called negative amortization,
this means the mortgage balance is increasing. The interest shortage in
the payment is automatically added to the loan, , and interest may be
charged on that amount. The borrower therefore might owe the lender more
later in the loan term than at the start. However, an increase in the
value of the home might make up for the increase in the amount owed
because of negative amortization.
Some loans allow negative amortization but have a cap on the
rate of negative amortization possible.
Convertible ARMs. A convertible Arm clause
is one that allows borrower to convert ARM to fixed rate loan at
designated times. When a borrower converts, the new rate is generally set
at the current market rate for fixed rate loans plus at least .375 or 1 %
as a servicing premium.
Assumable ARMs. Although the majority of
Arms are assumable, lenders normally place conditions on the assumption of
the loan. The lender may require that the new borrower supply credit
information, complete a credit application, and meet the customary credit
standards applied by each lender.
Some lenders allow only one assumption. Other lenders allow
assumption but adjust the overall cap or the margin to the rate in affect
at the time of assumption. Some lenders allow assumption with the original
lifetime cap already in affect.
