WHY SELECT AN ADJUSTABLE RATE
MORTGAGE
During the past several years, fixed rate financing has been the most often
selected form of home financing for most borrowers. With fixed rates continuing
to hover just below 5%, they remain the popular financing choice. As the rate
of property appreciation has moderated, homebuyers anticipate that they will
likely remain in any newly purchased home rather than "move up"
anytime soon. This may suggest that homeowners may stay in their homes for a
longer period of time . . . perhaps eight or more years. Regardless of the
"holding time", many homebuyers still prefer the comfort of knowing
what their payment is going to be each and every month as is the case with
fixed rate financing. On the other hand, when fixed interest rates increase,
Adjustable Rate Mortgages (ARM's) often become a bit
more popular. There are a few additional times when an ARM loan might make
sense.
IF THE BORROWER CAN QUALIFY FOR A LARGER LOAN AMOUNT: While this may
have been true several years ago, this may be more of a myth than reality in
today's ARM market. In the past, a borrower actually "qualified" at
the low ARM start rate which resulted in their being able to borrow more money
and purchase a more expensive home. Most ARM products today, however, require a
borrower to qualify at the "start rate plus 2%" or at the "fully
indexed rate". The latter is the "index" plus the margin. (i.e.;
we add the margin of 2.25% to an estimated 11th District Cost of Funds Index of
3.25% and the fully indexed/qualifying rate would be 6%). This "fully
indexed rate" is at best usually only approximately .5% less than a
comparable fixed rate and will hardly allow a borrower to qualify for much
additional loan amount.
WHEN A BORROWER WANTS LOWER INITIAL PAYMENTS: An ARM with a very low
start rate (i.e.; 1.75% to 2.5%) is more likely to have negative amortization
than a higher start rate loan. These "Neg Am" loans can result in an
erosion of one's equity. Typically, the borrower is provided the option each
month to pay (1) either the minimum payment , (2) a
higher payment that will, at least, pay all the interest, or (3) a payment
amount that will fully amortize the loan. While the initial payment amount may
be predicated on the initial low interest rate, the loan accrues interest at
the fully indexed rate (described above), resulting in
unpaid interest having to be added to the loan balance . . . this is the
"negative amortization" or "deferred interest". As home
appreciation rates remains minimal lenders are more reluctant to make this kind
of loan where equity is eroded.
While these loans may be less popular than a few years ago when double digit
appreciation more than equaled any negative amortization, this type of ARM
"controls the loan's payments" as they increase a maximum of only
7.5% each year. Thus, for those who need to have a low monthly payment and need
to know exactly the amount of each year's increase, these loans may be one
answer. These loans are more likely to have pre-payment penalties assessed
during the first three years of the loan. Depending upon the borrower's
specific need for lower initial payments, the 30 due in 3, 5 or 7 year fixed
rate might be an alternative to the ARM loan.
WHEN THE BORROWER WANTS TO MAKE PRINCIPAL REDUCTION PAYMENTS: In
those situations when a borrower desires to make significant principal
reduction payments, the "no-neg" ARM loan
(without a pre-payment penalty) may be appropriate as the payment will reduce
according to the amount of the principal reduction at the loan's next
adjustment date. This occurs most frequently when a buyer purchases prior to
selling a current residence. The intent is to extract their equity upon the
future sale of their residence and make a significant "principal pay
down" payment on the new loan.
Adjustable Rate Mortgages remain available in today's mortgage market place
albeit with lesser choices than in past years. There are times when an ARM
makes perfect sense. When acquiring such financing, a borrower must be certain
to understand all of the characteristics of the selected loan. It is important
to avoid surprises after the loan process has been completed and it is too late
to make adjustments to the loan terms.
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