A tutorial on ARMS (Adjustable Rate Mortgages)
In the Old Days you loaned the bank (savings) money and they gave you 3% interest. When
you needed money, (borrowing) they charged you 6%. But instead of your having to pay them
back right away, they let you re-borrow every year if you paid back just a little bit
(Amortized Loan). Every one was happy. Then things changed. Letting you re-borrow for a
long period of time caused a potential (and in the 1980's)a large loss. Lenders decided
that if you take some of the risk created in the costs of funds to the lender created by
higher interest rates he would give you a better interest rate today. If lenders cost to
borrow go down they would also lower your rate."
The advantage is lower rates now. The disadvantage is uncertainty.
An advantage of this lower interest rate A.R.M. is they are easier to qualify for.
Often, for the first time buyer, they are the only alternative.
There are several parameters regarding variable rate loans:
- The first is the Index (these are described extensively below.) The Index is
related to the cost to the lender. Different lender's have different costs of funds and
thus use different indices.
-
- The start rate is he initial interest rate. It may last for 3 months, 6 months, 1
year, or as long as 7 years. The longer the initial period the higher the rate.
-
- The margin is what is added to the value of the Index at the time of adjustment.
The result is generally rounded to the nearest 0.125%.
-
- The term cap describes how much the rate can go up or down when it adjusts. This
is more important for volatile indices. Generally, the limit is 1% every 6 months (if the
loan adjusts every 6 months) or 2% a year if it adjusts once a year.
-
- The life cap or ceiling is the highest interest rate that the loan can
have during its entire life.
-
- Some loans have negative amortization features. A "negative
amortization" loan may start at 5% and have an initial payment of $1,000. Even though
the interest rate might adjust after 3 months you may be able to keep the start payment
for an entire year. Your loan balance will go up if you choose to make the minimal
payment. The minimal payment will go up by 7.5% from year to year. Depending on the loan
program the "negative amortization" feature will cease when your loan balance
reaches between 110% to 120% of the original loan amount. The "negative
amortization" does not extend the life of the loan.
Definition of Common Adjustable Rate Indices
- COFI or 11th District Cost of Funds.
- PROPER NAME: Monthly Weighted Average Cost of Funds for 11th District SAIF-Insured
Institutions.
- This index, used primarily for ARMs with monthly interest rate adjustments, is
calculated by the Federal Home Loan Bank of San Francisco. The 11th District represents
the SAIF-insured savings institutions (savings & loan associations and savings banks)
in Arizona, California and Nevada.
The cost of funds reflects the interest rates paid by
institutions for savings accounts, FHLB advances, money borrowed from commercial banks,
and other sources.
Since the largest part of a cost of funds index is interest paid on savings accounts,
this index lags behind the economy. As a result, ARMs tied to this index rise (and fall)
more slowly than rates in general. However, such ARMs often have payment caps, but no
month-to-month interest rate caps.
This index is available by calling (303)444-6880. The value changes once a month and is
published at 3 P.M. on the last day of each month.
- 1 Year T-Bill
- PROPER NAME: Yield on Treasury Security Adjusted to a Constant Maturity of One Year
- The One-Year Treasury Security index (or "T-Sec") is associated with ARMs that
feature annual rate adjustments. It is calculated by the Federal Reserve Board and has
both a weekly and monthly value; most lenders use the weekly value. This index reflects
the state of the economy, and responds quickly to economic changes.
Confusion can arise
when some lenders use the term "one year Treasury bill." Most one-year ARMs --
but not all -- are tied to the Constant Maturity of the One Year Treasury Security.
This index is available on a recording at (415)974-2859
- LIBOR
- Stands for London Interbank Offered Rate. It is a measure of commercial lending rates of
a group of London banks. It is similar to Prime. It moved up and down rapidly. It can best
be obtained daily from the Wall Street Journal.
-
- 6 Mos. CD
- This is a measure of what banks are paying on 6 month certificates of deposit. It moves
less rapidly than LIBOR or T-bill but more rapidly than COFI.