Adjustable-Rate Loans: Go Figure
Adjustable-rate mortgages are near their cheapest levels in history, and that’s making them increasingly popular, some lenders say. Home Savings of America, for example, reports that 84% of the loans funded during the past month have been ARMs, versus 65% earlier this year.
And with ARM rates starting out at around 5% versus roughly 8% for fixed-rate loans--one of the biggest spreads ever--it’s no wonder that consumers are looking toward ARMs. Savvy consumers who plan to move or refinance within five years can potentially save thousands of dollars.
However, those who opt for adjustable-rate loans must be cautious. ARMs are far more complicated than their fixed-rate counterparts.
Where consumers essentially just shop for rates and points when getting a fixed loan, those taking out adjustable mortgages must be on the lookout for favorable loan terms as well as good rates. Indeed, the loan terms may be more important than the initial rate in the long run.
Here are terms savvy consumers should know about:
* Interest rate caps: A good adjustable loan will offer both annual and lifetime limits on how high the interest rate can go.
* Adjustment periods: Some lenders adjust loan rates just once annually, while others adjust the rate once a month. When interest rates are rising, it’s best to have fewer adjustment periods, and vice versa.
* Index: Adjustable loans are tied to one of several indexes. The most common are those based on one-year Treasury bills, short-term certificates of deposit, the London Interbank Offered Rate (LIBOR) or the so-called 11th District Cost of Funds. The first three indexes are relatively volatile--they tend to move up and down reasonably quickly. And the LIBOR rate is partly based on international interest rates, which are currently far higher than domestic rates.
The 11th District rate, on the other hand, moves in a glacial fashion. It’s currently about 1.5 percentage points higher than the more volatile indexes, but it can be attractive to those who can’t handle large rate swings.
* Convertability: Some adjustable loans can be converted into fixed-rate loans if and when the homeowner decides it is to his or her advantage to do so.
* Payment caps: These guarantee that regardless of what happens to interest rates, the borrower’s monthly payment won’t change dramatically. But payment caps generally don’t reduce the amount you owe--just the amount you pay. In fact, if a payment cap kicks in, you’re likely to end up owing more over the long run because of something called negative amortization.
When would you want a payment cap? When you think it’s likely that your income won’t keep pace with the potential hikes in your mortgage payments, or when you think you could invest the differential at a profit.
To illustrate the importance of these loan terms, consider two hypothetical borrowers who each take out $100,000 mortgages.
Borrower A gets an initial “teaser” rate of 4.5%, fixed for three months; Borrower B gets a 5.5% teaser rate that’s fixed for a year. Both loans float at 3 percentage points above the one-year Treasury bill index, currently around 3.5%.
Borrower A’s loan has no interest rate caps, but it does have a 7.5% annual payment cap, meaning the payment cannot rise more than that percentage each year. Borrower B’s loan has a 2 percentage point annual interest rate cap and a 6 percentage point lifetime interest rate cap. It has no payment caps.
Assuming the Treasury index stays constant for one year, Borrower A pays $507 monthly for the first three months, then his loan hikes up to the “fully-phased-in” rate of 6.5%. That would push Borrower A’s monthly payments to $632. However, because he’s got a 7.5% payment cap, his monthly payments only rise to $545. What happens to the other $87? It gets added on to the balance of his loan. That’s negative amortization.
At the end of the year, Borrower A has paid $6,426 on his $100,000 loan, but because of the negative amortization, he owes about $100,800.
Meanwhile, Borrower B’s 5.5% loan costs $568 monthly, or $6,816 during the year. But by the end of the year, he’s paid off a modest amount of principal. In year two, assuming the Treasury index hasn’t moved, Borrower B’s rate jumps up to the fully-phased-in rate of 6.5%, hiking his monthly payments to about $630, or $7,560 per year.
Borrower A’s payments hike to $586. But he’s still accruing a negative balance of about $50 monthly. By the end of the second year, he’s paid nearly $13,500. But he now owes about $101,400 on his $100,000 loan. In other words, he’s been sheltered from payment shock, but he’s fast eating into the equity he invested in his home.
What happens after five years, assuming that the index that both loans are tied to has jumped 6 percentage points?
Borrower B hit the lifetime rate cap on his loan at 11.5%, which means his monthly payments capped out at around $990. He’s also still slowly whittling down the balance of his loan.
Borrower A now owes more than $105,000 and his interest rate has risen to 12.5%. To avoid further negative amortization, he must pay about $1,200 monthly. However, the payment cap may have made this home affordable, when it otherwise wouldn’t have been. And he may have invested the money he saved each month in the stock market or another investment, which may have grown enough in value to offset the rise in his loan principal.
