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These indexes are the weekly or monthly average yields on U.S. Treasury securities adjusted to constant maturities. Constant Maturity Treasuries is a set of "theoretical" securities based on the most recently auctioned "real" securities: 1-, 3-, 6-month bills, 2-, 3-, 5-, 10-, 30-year notes, and also the 'off-the-runs' in the 7- to 20-year maturity range. The Constant Maturity Treasury rates are also known as "Treasury Yield Curve Rates". Yields on Treasury securities at "constant maturity" are interpolated by the U.S. Treasury from the daily yield curve, which is based on the closing market bid yields on actively traded Treasury securities in the over-the-counter market. The CMT indexes are volatile and move with the market. They reflect the state of the economy, and respond quickly to economic changes. These indexes react more slowly than the CD index, but more quickly than the COF index or the MTA index.  The following CMT indexes are the most often used for ARMs:
The index is the weighted average rate of initial mortgage interest rates paid by home buyers reported by a sample of mortgage lenders for loans closed for the last 5 working days of the month. The weights are determined by the type, size and location of the lender. The rate is based on conventional fixed and adjustable rate mortgages on previously occupied non-farm single-family homes. The National Average Contract Mortgage Rate is derived from the Federal Housing Finance Board's Monthly Interest Rate Survey (MIRS) and is reported by the FHFB on a monthly basis. Many lenders use this rate to reset the interest rate on ARMs. In the early 1980s, it was the only index rate that federally chartered savings and loan associations could use as an adjustable rate mortgage index. The full name of the index is: 'National Average Contract Mortgage Rate For the Purchase of Previously Occupied Homes By Combined Lenders'. The index is also sometimes referred to as the National Mortgage Contract Interest Rate. Banks may publish a prime lending rate which
is used as the index. The index
is then created as the rate plus some margin.
To apply an index on a rate plus margin basis means that the
interest rate will equal the underlying index plus a margin.
The margin is specified in the note. Terminology
PopularityFixed rate mortgages are the most classic form of loan for home and product purchasing in the United States. The most common terms are 15-year and 30-year mortgages, but shorter terms are available, and 40-year and 50-year mortgages are now available (common in areas with high priced housing, where even a 30-year term leaves the mortgage amount out of reach of the average family). PricingFixed rate mortgages are usually more expensive than adjustable rate mortgages. Due to the inherent interest rate risk, long-term fixed rate loans will tend to be at a higher interest rate than short-term loans. The difference in interest rates between short and long-term loans is known as the yield curve, which generally slopes upward (longer terms are more expensive). The opposite circumstance is known as an inverted yield curve and is relatively infrequent. The fact that a fixed rate mortgage has a higher starting interest rate does not indicate that this is a worse form of borrowing compared to the adjustable rate mortgages. If interest rates rise, the ARM cost will be higher while the FRM will remain the same. In effect, the lender has agreed to take the interest rate risk on a fixed rate loan. Some studies have shown that the majority of borrowers with adjustable rate mortgages save money in the long term, but that some borrowers pay more. The price of potentially saving money, in other words, is balanced by the risk of potentially higher costs. In each case, a choice would need to be made based upon the loan term, the current interest rate, and the likelihood that the rate will increase or decrease during the life of the loan. PrepaymentFixed rate mortgages, like other types of mortgage, may offer the ability to prepay principal (or capital) early without penalty. Early payments of part of the principal will reduce the total cost of the loan (total interest paid), and will shorten the amount of time needed to pay off the loan. Early payoff of the entire loan amount through refinancing is sometimes done when interest rates drop significantly. Adjustable rate mortgageAn adjustable rate mortgage (ARM), variable rate mortgage or floating rate mortgage is a mortgage loan where the interest rate on the note is periodically adjusted based on an index. This is done to ensure a steady margin for the lender, whose own cost of funding will usually be related to the index. Consequently, payments made by the borrower may change over time with the changing interest rate (alternatively, the term of the loan may change). This is not to be confused with the graduated payment mortgage, which offers changing payment amounts but a fixed interest rate. Other forms of mortgage loan include interest only mortgage, fixed rate mortgage, negative amortization mortgage, and balloon payment mortgage. Adjustable rates transfer part of the interest rate risk from the lender to the borrower. They can be used where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate falls and loses out if interest rates rise. Adjustable rate mortgages are characterized by their index and limitations on charges (caps). In U.S & many countries, adjustable rate mortgages are the norm, and in such places, may simply be referred to as mortgages. Characteristics of the ARM loans
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1 Year Constant Maturity Treasury Rate |
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Month |
1997 |
1998 |
1999 |
2000 |
2001 |
2002 |
2003 |
2004 |
2005 |
2006 |
2007 |
|
Jan |
5.61% |
5.24% |
4.51% |
6.12% |
4.81% |
2.16% |
1.36% |
1.24% |
2.86% |
4.45% |
5.06% |
|
Feb |
5.53% |
5.31% |
4.70% |
6.22% |
4.68% |
2.23% |
1.30% |
1.24% |
3.03% |
4.68% |
5.05% |
|
Mar |
5.80% |
5.39% |
4.78% |
6.22% |
4.30% |
2.57% |
1.24% |
1.19% |
3.30% |
4.77% |
4.92% |
|
Apr |
5.99% |
5.38% |
4.69% |
6.15% |
3.98% |
2.48% |
1.27% |
1.43% |
3.32% |
4.90% |
4.93% |
|
May |
5.87% |
5.44% |
4.85% |
6.33% |
3.78% |
2.35% |
1.18% |
1.78% |
3.33% |
5.00% |
4.91% |
|
Jun |
5.69% |
5.41% |
5.10% |
6.17% |
3.58% |
2.20% |
1.01% |
2.12% |
3.36% |
5.16% |
|
|
Jul |
5.54% |
5.36% |
5.03% |
6.08% |
3.62% |
1.96% |
1.12% |
2.10% |
3.64% |
5.22% |
|
|
Aug |
5.56% |
5.21% |
5.20% |
6.18% |
3.47% |
1.76% |
1.31% |
2.02% |
3.87% |
5.08% |
|
|
Sep |
5.52% |
4.71% |
5.25% |
6.13% |
2.82% |
1.72% |
1.24% |
2.12% |
3.85% |
4.97% |
|
|
Oct |
5.46% |
4.12% |
5.43% |
6.01% |
2.33% |
1.65% |
1.25% |
2.23% |
4.18% |
5.01% |
|
|
Nov |
5.46% |
4.53% |
5.55% |
6.09% |
2.18% |
1.49% |
1.34% |
2.50% |
4.33% |
5.01% |
|
|
Dec |
5.53% |
4.52% |
5.84% |
5.60% |
2.22% |
1.45% |
1.31% |
2.67% |
4.35% |
4.94% |
|
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Copyright 2007 www.iMortgagesites.com |
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Treasury Bill (T-Bill)
These indexes are based on the results of auctions that the U.S. Treasury holds for its Treasury bills, notes and bonds. Treasury bills are issued by the U.S. government with maturities of 1, 3 and 6 months (4-week, 13-week, 26-week bills or 28-day, 91-day, 182-day bills) in order to pay for the national debt and other expenses. The 3- and 6-month Treasury bills are auctioned every Monday and the resulting figures are released to the public the next day. Treasury bill auction results provide the discount rate, investment yield, and price for recently auctioned bills.
The discount rate is an annualized rate of return based on the par value of the bills and is calculated on a 360-day basis. The investment yield, or coupon-equivalent yield, is calculated on a 365-day basis and is an annualized rate based on the purchase price of the bills and reflects the actual yield to maturity.
Treasury bills can be bought at original issue or on the secondary market. At original issue, the Treasury Department sells new securities to the public. On the secondary market, traders buy and sell previously issued securities.
Following is the definition of the weekly 6-Month T-Bill index (Auction High):
The Weekly 6-Month T-Bill (Auction High) Mortgage (ARM) Index is the discount rate for the 26-week Treasury Bill bought at original issue (at the most recent auction of U.S. Treasury bills). The current value generally reflects the previous week-ending date (previous Friday).
T-Bill indexes have both weekly and monthly values. Monthly values are averages of the past month's weekly T-Bill rates.
The monthly 6-Month Treasury Bill index (6-MoT-Bill) is the most often used. ARMs tied to the 6-Month T-Bill usually adjust once every six months. The Treasury Bill indexes move with the market and respond quickly to economic changes like the CMT indexes. The following graph reflects the movement of the 3-, and 6-Month monthly Treasury Bills and compares them with the monthly 1-Year CMT index.
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12-month Treasury Average Index (MTA)
This rate is updated after the Federal Reserve releases its data on the first Monday of each month. This index is the 12 month average of the monthly average yields of U.S. Treasury securities adjusted to a constant maturity of one year. In plain English, this index is calculated by averaging the previous 12 rates of the 1 Year CMT. Because this particular index is an annual average, it is steadier than the 1 Year Treasury Index. It fluctuates slightly more than the 11th District Cost of Funds, although its movements track each other very closely, as shown on our comparison charts. The terms 12 MTA (12 month treasury average) and 12 MAT (12 month average treasury) are used interchangeably.
Historical Graph
Historical Graph
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12
Month Treasury Average (12 |
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|
Month |
1997 |
1998 |
1999 |
2000 |
2001 |
2002 |
2003 |
2004 |
2005 |
2006 |
2007 |
|
Jan |
5.610% |
5.599% |
4.991% |
5.212% |
5.999% |
3.260% |
1.935% |
1.234% |
2.022% |
3.751% |
4.983% |
|
Feb |
5.570% |
5.581% |
4.940% |
5.338% |
5.871% |
3.056% |
1.858% |
1.229% |
2.171% |
3.888% |
5.014% |
|
Mar |
5.647% |
5.547% |
4.889% |
5.458% |
5.711% |
2.912% |
1.747% |
1.225% |
2.347% |
4.011% |
5.027% |
|
Apr |
5.733% |
5.496% |
4.832% |
5.580% |
5.530% |
2.787% |
1.646% |
1.238% |
2.504% |
4.143% |
5.029% |
|
May |
5.760% |
5.460% |
4.783% |
5.703% |
5.318% |
2.668% |
1.548% |
1.288% |
2.633% |
4.282% |
5.022% |
|
Jun |
5.748% |
5.437% |
4.757% |
5.793% |
5.102% |
2.553% |
1.449% |
1.381% |
2.737% |
4.432% |
|
|
Jul |
5.719% |
5.422% |
4.729% |
5.880% |
4.897% |
2.414% |
1.379% |
1.463% |
2.865% |
4.563% |
|
|
Aug |
5.699% |
5.393% |
4.728% |
5.962% |
4.671% |
2.272% |
1.342% |
1.522% |
3.019% |
4.664% |
|
|
Sep |
5.679% |
5.325% |
4.773% |
6.035% |
4.395% |
2.180% |
1.302% |
1.595% |
3.163% |
4.758% |
|
|
Oct |
5.657% |
5.213% |
4.883% |
6.083% |
4.088% |
2.123% |
1.268% |
1.677% |
3.326% |
4.827% |
|
|
Nov |
5.639% |
5.136% |
4.968% |
6.128% |
3.763% |
2.066% |
1.256% |
1.773% |
3.478% |
4.883% |
|
|
Dec |
5.630% |
5.052% |
5.078% |
6.108% |
3.481% |
2.002% |
1.244% |
1.887% |
3.618% |
4.933% |
|
|
Copyright 2007 iMortgageSites.com |
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Certificate of Deposit Index (CODI)
The Certificate of Deposit Index (CODI) is the 12 month average* of the monthly average yields on the nationally published 3-Month Certificate of Deposit rates.
Because this index is an annual average, it is more steady than CMT and CD indexes which are very volatile and generally considered to react quickly to change in the market. The CODI and MTA indexes generally fluctuate slightly more than the 11th District COFI, although their movements track each other very closely (as illustrated on our historical graph). The MTA, COFI and CODI-indexed ARMs work much the same way.
-
11th District Cost of Funds Index (COFI)
A monthly weighted average of the interest rates paid on checking and savings accounts offered by financial institutions operating in the states of Arizona, California and Nevada. Published on the last day of each month, the COFI represents the cost of funds for western American financial institutions. The COFI is computed using several different factors, with interest paid on savings accounts comprising the largest weighting in the average. Because of this, the index tends to exhibit low volatility and follow market interest rate changes somewhat slowly it is generally regarded as a two-month lagging indicator of market interest rates. Because it is computed using data from three western states, the COFI is primarily used in the western U.S. while the Treasury Index is the measure of choice in the east.
-
Cost of Savings Index (COSI)
- No longer exists as an index for new mortgages
- The new index: Wachovia Cost of Savings Index (Wachovia COSI or W-COSI)
Since the merger of Wachovia and World Savings the Wachovia family of companies no longer uses the original COSI index for new mortgages (though it is still being published for existing mortgages until they are migrated over to the Wachovia COSI).
The original COSI index (GDW COSI) was the weighted average of the rates of interest on the deposit accounts of the federally insured depository institution subsidiaries of Golden West Financial Corporation (GDW). All of the depository institution subsidiaries of Golden West Financial Corporation operated under the name World Savings.
World Savings receives money from consumers in the form of deposits and lends money as home or other loans. The interest rates in effect on these deposits were the basis for the GDW COSI index. It was not based on actual interest paid, but rather the weighted annualized average of all interest rates in effect on World Savings deposit accounts on the last day of each month.Both the original COSI (GDW COSI) and the W-COSI (Wachovia COSI) adjust monthly and have a one-month reporting lag. They are computed on the last day of each calendar month and are announced on or near the last business day prior to the fifteenth day of the following calendar month.
The Cost of Savings index considered to be among the most stable ARM indexes in the industry. It is one of the most widely used Option ARM loan indexes.
Many COSI-indexed ARMs often have minimum payment change caps (usually, up to 7.5% of minimum payment amount), as well as lifetime interest rate caps (usually, about 12%) but no periodic interest rate caps creating the possibility for negative amortization. -
London Interbank offered Rate (LIBOR)
London Interbank Offered Rate (or LIBOR, pronounced LIE-bore) is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market). LIBOR is the opposite of the London Interbank Bid Rate (LIBID).
The (LIBOR) index is the weighted average rate of initial mortgage interest rates paid by home buyers reported by a sample of mortgage lenders for loans closed for the last 5 working days of the month. The weights are determined by the type, size and location of the lender. The rate is based on conventional fixed and adjustable rate mortgages on previously occupied non-farm single-family homes.
LIBOR-indexed ARMs offer borrowers aggressive initial rates (lower than many other ARMs) and has proved to be competitive with such popular ARM indexes as the 11th District Cost of Funds, the 6-Month Treasury Bill, and the 6-Month Certificate of Deposit. With the LIBOR ARMs borrowers are generally protected from wide fluctuations in interest rates by periodic and lifetime interest rate caps. LIBOR ARMs usually do not have negative amortization.
LIBOR is published by the British Bankers Association (BBA) shortly after 11:00 each day, London time, and is a filtered average of inter-bank deposit rates offered by designated contributor banks, for maturities ranging from overnight to one year. The shorter rates, i.e. up to 6 months, are usually quite reliable and tend to precisely reflect market conditions at measurement time. The actual rate at which banks will lend to one another will, however, continue to vary throughout the day. Apart from the US dollar and, of course Pound Sterling, currencies for which LIBOR is a significant reference rate currently include the Swiss Franc, the Yen6, the Canadian dollar and the Danish Krone.
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Certificates of Deposit (CD) Indexes
These indexes are averages of the secondary market interest rates on nationally traded Certificates of Deposit. The Certificates of Deposit, also known as CDs, are usually issued by banks and other financial institutions. They pay a fixed rate of interest for a specific period of time.
The Certificates of Deposit of various maturities, including 1-Month, 3-Month, 6-Month and 1-Year, are used as ARM indexes. The 6-Month Certificate of Deposit (6-Mo CD) is the most popular of the CD indexes.
The 12-month moving average of the monthly 3-Month CD is called CODI.
The CD indexes are very volatile and generally considered to react quickly to change in the market, which is good for you if rates are falling but not good for you if rates are rising. Look at how the 6-Month CD changes:
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Bank Prime Loan (Prime Rate)
prime rateThe minimum interest rate charged by a commercial bank on short-term business loans to large, best-rated customers or corporations.
Also called Prime, Prime Interest Rate, Prime Lending rate.
Historically, in North American banking, the prime rate was the interest rate charged by lenders to borrowers whom they considered most creditworthy, although this is no longer the case. The prime rate varies little among banks, and adjustments are generally made by banks at the same time, although this does not happen with great frequency. The prime rate is currently 8.25% in the United States (verified May 2, 2007), according to data published by the Federal Reserve Bank of Saint Louis. Canadian prime rate is currently 6.00% by Bank of Canada (verified May 2, 2007). The prime rate is one of the ways the central bank, such as the Federal Reserve, uses to control the spending habits of consumers.
Overview of the Prime Rate
In general, the prime rate runs approximately 300 basis points (3 percentage points) above the Federal Funds Rate, the interest rate that banks charge to each other for overnight loans made to fulfill reserve funding requirements. (The Federal funds rate plus a much smaller increment is frequently used for lending to the most creditworthy borrowers today, as is LIBOR, the London Interbank Offered Rate.) The Federal Open Market Committee (FOMC) meets eight times per year wherein they set a target for the federal funds rate. Other rates, including the Prime Rate, derive from this base rate.
The most commonly recognized prime rate index is the Wall Street Journal Prime Rate (WSJ Prime Rate), published in the Wall Street Journal. Unlike other indexed rates, the prime rate does not change on a regular basis; rather, it changes whenever banks need to alter the rates at which borrowers obtain funds. The WSJ defines the prime rate as "The base rate on corporate loans posted by at least 75% of the nation's 30 largest banks." It has been speculated though that this is no longer the real definition, (and that the prime rate is simply the fed funds target rate + 3) because most corporate loans are indexed to LIBOR.
When 23 out of 30 of the United States' largest banks change their prime rate, the WSJ prints a composite prime rate change.
Uses of the Prime Rate
The Prime Rate is used often in calculating mortgages and other variable rate loans. It is used in the calculation of some private student loans. Many credit cards with variable
The Prime Rate is the interest rate charged by banks for short-term loans to their most creditworthy customers whose credit standing is so high that little risk to the lender is involved. Only a small percentage of customers qualify for the prime rate, which tends to be the lowest going interest rate and thus serves as a basis for other, higher risk loans.
The rate is almost always the same amongst major banks. Adjustments to the prime rate are made by banks at the same time; although, the prime rate does not adjust on any regular basis. The prime rate is not very volatile index however it generally rises quickly but declines very slowly.
Many home-equity loans and lines of credit are tied to the prime rate as published in the Wall Street Journal. The Journal number is derived from the rate posted by at least 75 percent of the 30 largest U.S. banks. -
Fannie Mae's Required Net Yield (RNY)
Strictly speaking, this is not an ARM index, however it is included here because this yield is frequently used as a basis for converting an adjustable rate mortgage to a fixed rate mortgage. Fannie Mae has many different yields.
Fannie Mae, a federally chartered, shareholder-owned company, is the nation's largest source of funds for mortgages. It purchases mortgages from lenders, freeing up cash so the lenders can make more loans.
To determine exactly which Fannie Mae yield your mortgage is tied to, you should contact your current mortgage lender or look in your mortgage note. The most popular yield for 30-year fixed rate mortgages is the 60-day delivery RNY -- the minimum yield that Fannie Mae require on any given day for 30-year fixed rate mortgages delivered for sale to Fannie Mae by lenders within 60 days. -
National Average Contract Mortgage Rate
The index is the weighted average rate of initial mortgage interest rates paid by home buyers reported by a sample of mortgage lenders for loans closed for the last 5 working days of the month. The weights are determined by the type, size and location of the lender. The rate is based on conventional fixed and adjustable rate mortgages on previously occupied non-farm single-family homes.
The National Average Contract Mortgage Rate is derived from the Federal Housing Finance Board's Monthly Interest Rate Survey (MIRS) and is reported by the FHFB on a monthly basis.
Many lenders use this rate to reset the interest rate on ARMs. In the early 1980s, it was the only index rate that federally chartered savings and loan associations could use as an adjustable rate mortgage index.
The full name of the index is: 'National Average Contract Mortgage Rate For the Purchase of Previously Occupied Homes By Combined Lenders'. The index is also sometimes referred to as the National Mortgage Contract Interest Rate.- The index rate was calculated for loans closed during the first 5 working days of the month up through October 1991.
- Prior to October 1989, the Monthly Interest Rate Survey was conducted by the former Federal Home Loan Bank Board (FHLBB).
Banks may publish a prime lending rate which is used as the index. The index is then created as the rate plus some margin. To apply an index on a rate plus margin basis means that the interest rate will equal the underlying index plus a margin. The margin is specified in the note.
What are the Limitations on charges (caps)?
Any mortgage where payments made by the borrower may increase over time brings with it the risk of financial hardship to the borrower. To limit this risk, limitations on charges-known as caps in the industry-are a common feature of adjustable rate mortgages. Caps typically apply to three characteristics of the mortgage:
- frequency of the interest rate change
- periodic change in interest rate
- total change in interest rate over the life of the loan, sometimes called life cap
For example, a given ARM might have the following types of caps:
Interest rate adjustment caps:
- interest adjustments made every 6 months, typically 1% per adjustment, 2% total per year
- interest adjustments made only once a year, typically 2% maximum
- interest rate may adjust no more than 1% in a year
Mortgage payment adjustment caps:
- maximum mortgage payment adjustments of 5% a year, which is common with pay-option / negative amortization loans
Life of loan interest rate adjustment caps:
- total interest rate adjustment limited to 5% of the life of the loan. Most common is 6% lifetime caps.
Caps on the periodic change in interest rate may be broken up into one limit on the first periodic change and a separate limit on subsequent periodic change, for example 5% on the initial adjustment and 2% on subsequent adjustments.
Another common cap is a limitation on the maximum monthly payment expressed in absolute rather than relative terms, for example $1000 a month.
ARMs which allow negative amortization may have a payment adjustment frequency which differs from the interest rate adjustment frequency. For example, the interest rate may be adjusted every six months, but the payment amount only once every 12 months.
Cap structure is sometimes expressed as initial adjustment cap / subsequent adjustment cap / life cap, for example 2/2/5 for a loan with a 2% cap on the initial adjustment, a 2% cap on subsequent adjustments, and a 5% cap on total interest rate adjustments. When only two values are given, this indicates that the initial change cap and periodic cap are the same. For example, a 2/2/5 cap structure may sometimes be written simply 2/5.
What are the Reasons Banks Prefer ARMs? |
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| In many countries, banks or similar financial
institutions are the primary originators of mortgages. For banks
that are funded from customer deposits, the customer
deposits will typically have much shorter terms than residential
mortgages. If a bank were to offer large volumes
of mortgages at fixed rates but to derive most of its funding
from deposits (or other short-term sources of funds), the bank
would have an asset-liability mismatch: in this case, it would
be running the risk that the interest income from its mortgage
portfolio would be less than it needed to pay its depositors.
In the United States, some argue that the savings and loan crisis
was in part caused by this problem, that the savings and loans
companies had short-term deposits and long-term, fixed rate mortgages,
and were caught when "Paul Volcker" raised interest
rates in the early 1980s. |
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To avoid this risk, many mortgage originators will sell or securitize their mortgages. Banking regulators pay close attention to asset-liability mismatches to avoid such problems, and place tight restrictions on the amount of long-term fixed-rate mortgages that banks may hold (in relation to their other assets). In this perspective, banks and other financial institutions offer adjustable rate mortgages because it reduces risk and matches their sources of funding. For the borrower, adjustable rate mortgages may be less expensive, but at the price of higher risk borne by the borrower. In 'most' situations, short-term borrowing is less expensive than long-term borrowing, due to the slope of the yield curve. If rates are expected to rise, however, or the yield curve is sloped down (long-term money is less expensive than short-term money) borrowers may end up paying more over the life of the mortgage loan. |
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What are ARM Variants? |
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Hybrid ARMsA hybrid adjustable-rate mortgage (ARM) is one where the interest rate on the note is fixed for a period of time, then floats thereafter. The "hybrid" refers to the blend of fixed rate and adjustable rate characteristics found in hybrid ARMs. Hybrid ARMs are referred to by their initial fixed period and adjustment periods, for example 3/1 for an ARM with a 3-year fixed period and subsequent 1-year rate adjustment periods. The date that a hybrid ARM shifts from a fixed-rate payment schedule to an adjusting payment schedule is known as the reset date. After the reset date, a hybrid ARM floats at a margin over a specified index just like any ordinary ARM. The popularity of hybrid ARMs
has significantly increased in recent years. In 1998, the percentage
of hybrids relative to 30-year fixed rate mortgages was less than
2%; within 6 years, this increased to 27.5%. |
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Like other adjustable-rate products, hybrid ARMs transfer some interest rate risk from the lender to the borrower, thus allowing the lender to offer a lower note rate. Option ARMsAn "option ARM" is a loan where the borrower has the option of making a specified minimum payment, an interest-only payment, or a 15-year or 30-year fixed rate payment in a given month. Four options for a Payment:
This type of loan is also known and advertised as the "pick a payment" or "pay-option" loan. When a borrower makes a payment that is less than the interest payment, there is negative amortization, where the unpaid interest is added back onto the principal balance. Option ARMs are popular because they are usually offered with a very low initial interest rate (a so-called "teaser rate") and a low minimum payment, which permits borrowers to qualify for a much larger loan than would otherwise be possible. When pricing an Option ARM, never focus on the Start Rate of 1% or 2%, consider only the Fully Indexed Rate (FIR) which is the Margin and the current Index being used (12-MTA, LIBOR, etc.). Option ARMs are best suited to people in fields with sporadic income, such as some self-employed people or those in a highly seasonal business. For example, someone who makes the majority of their income around the winter holiday season, but who earns minimal income during the following few months may wish to pay the full payment during their busy season, but drop back to the interest-only payment or the minimum during a period of reduced earnings. This gives greater flexibility to how the mortgage is paid. With a fixed-payment loan, if the borrower was unable to meet the fixed payment, they would risk late fees or foreclosure. The main risk of an Option ARM is "payment shock", when the negative amortization reaches a stated maximum, at which point the minimum payment will be raised to a level that amortizes the loan balance. The function of the loan that can cause this payment shock is called the "Recast" cap. The recast will happen when the original loan balance reaches 110% to 125% of the original loan balance due to negative amortization of making the minimum payment. For example: a $200,000 with a 110% recast cap will adjust to a fully indexed, fully amortized payment based on the remaining term of the loan when the negative amortization add to the loan balance reaches $220,000. If it was a 125% recast this will happen when loan balance reaches $250,000. Obviously the higher the recast cap the longer it will take for the recast to take place and the more negative amortization can be added to the loan balance. Another risk, as with any loan with potential negative amortization,
is that the increased loan balance will reduce or eliminate the
borrower's equity in the financed property, or if the value of
the property declines, increase the chance that he won't be able
to sell the property for an amount that will repay the loan. Option ARM mortgages are increasingly available in Hybrid, or temporarily Fixed Rate varieties, from 3 to 10 years, mitigating certain negative amortization characteristics of the popular Adjustable Rate variety. Largely as a result of yield curve inversion, a handful of banks have introduced 30 year fixed rate mortgages with option ARM style minimum payments. ARM Terminology
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What are Loan Caps? |
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| Loan caps provide payment protection against payment shock, and allow a measure of interest rate certainty to those who gamble with initial fixed rates on ARM loans. There are three types of Caps on a typical First Lien Adjustable Rate Mortgage or First Lien Hybrid Adjustable Rate Mortgage. Initial Adjustment Rate CapThe majority of loans have a higher cap for initial adjustments that's indexed to the initial fixed period. In other words, the longer the initial fixed term, the more the bank would like to potentially adjust your loan. Typically, this cap is 2-3% above the Start Rate on a loan with an initial fixed rate term of 3 years or lower and 5-6% above the Start Rate on a loan with an initial fixed rate term of 5 years or greater. |
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Rate Adjustment CapThis is the maximum amount by which an Adjustable Rate Mortgage may increase on each successive adjustment. Similar to the initial cap, this cap is usually 1% above the Start Rate for loans with an initial fixed term of 3 years or greater and usually 2% above the Start Rate for loans that have an initial fixed term of 5 years or greater. Lifetime CapMost First Mortgage loans have a 5% or 6% Life Cap above the Start Rate (this ultimately varies by the lender and credit grade). Industry Shorthand for ARM CapsInside the business caps are expressed most often by simply the 3 numbers involved that signify each cap. For example, a 5/1 Hybrid ARM may have a cap structure of 5/2/5 (5% initial cap, 2% adjustment cap and 5% lifetime cap) and insiders would call this a 5-2-5 cap. Alternately a 1 year arm might have a 1/1/6 cap (1% initial cap, 1% adjustment cap and 6% lifetime cap) known as a 1-1-6, or alternately expressed as a 1/6 cap (leaving out one digit signifies that the initial and adjustment caps are identical). Negative amortization ARM capsSee the complete article for the type of ARM that Negative amortization loans are by nature. Higher risk products, such as First Lien Monthly Adjustable loans with Negative amortization and Home Equity Lines of Credit aka HELOC have different ways of structuring the Cap than a typical First Lien Mortgage. The typical First Lien Monthly Adjustable loans with Negative amortization loan have a life cap for the underlying rate (aka "Fully Indexed Rate") between 9.95% and 12% (maximum assessed interest rate). Some of these loans can have much higher rate ceilings. The fully indexed rate is always listed on the statement, but borrowers are shielded from the full effect of rate increases by the minimum payment, until the loan is recast, which is when principal and interest payments are due that will fully amortize the loan at the fully indexed rate. Home Equity Lines of Credit HELOCSince HELOCs are intended by banks to primarily sit in second lien position, they normally are only capped by the maximum interest rate allowed by law in the state wherein they are issued. For example, Florida currently has an 18% cap on interest rate charges. These loans are risky in the sense that to lenders, they are practically a credit card issued to the borrower, with minimal security in the event of default. They are risky to the borrower in the sense that they are mostly indexed to the Wall Street Journal Prime Rate, which is considered a Spot Index, or a financial indicator that is subject to immediate change (as are the loans based upon the Prime Rate). The risk to borrower being that a financial situation causing the Federal Reserve to raise rates dramatically) would effect an immediate rise in obligation to the borrower, up to the capped rate. |
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Pricing of the ARM Mortgage? |
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| Adjustable rate mortgages are typically, but not always, less expensive than fixed-rate mortgages. Due to the inherent interest rate risk, long-term fixed rates will tend to be higher than short-term rates (which are the basis for variable-rate loans and mortgages). The difference in interest rates between short and long-term loans is known as the yield curve, which generally slopes upward (longer terms are more expensive). The opposite circumstance is known as an inverted yield curve and is relatively infrequent. The fact that an adjustable rate mortgage has a lower starting
interest rate does not indicate what the future cost of borrowing
will be (when rates change). If rates rise, the cost will be higher;
if rates go down, the rate will be lower. In effect, the borrower
has agreed to take the interest rate risk. Some studies have shown
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on average, the majority of borrowers with adjustable rate mortgages save money in the long term; but they have also demonstrated that some borrowers pay more. The price of potentially saving money, in other words, is balanced by the risk of potentially higher costs. PrepaymentAdjustable rate mortgages, like other types of mortgage, may offer the ability to repay principal (or capital) early without penalty. Early payments of part of the principal will reduce the total cost of the loan (total interest paid), and will shorten the amount of time needed to pay off the loan. Early payoff of the entire loan amount through refinancing is sometimes done when interest rates drop significantly. CriticismAdjustable rate mortgages are sometimes sold to unsophisticated consumers who are unlikely to be able to repay the loan should interest rates rise. In the United States, extreme cases are characterized by the Consumer Federation of America as predatory loans. Protections against interest rate rises include
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What are the types of Mortgages? |
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What is an Assumed mortgage? In real estate an assumed mortgage occurs when a buyer of a
real property is transferred all the obligations of the seller's
mortgage. |
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What is a Balloon mortgage? A balloon payment mortgage is a mortgage which does not fully
amortize over the term of the note, thus leaving a balance due
at maturity. The final payment is called a balloon payment
because of its large size. Balloon payment mortgages are more
common in commercial real estate than in residential real estate.
A balloon payment mortgage may have a fixed or a floating interest
rate. What is a Blanket loan?A blanket loan, or blanket mortgage, is a type of loan used to fund the purchase of more than one piece of real property. Blanket loans are popular with builders and developers who buy large tracts of land, then subdivide them to create many individual parcels to be gradually sold one at a time. Rather than securing a new mortgage each time a portion of the development is sold, the borrower uses the blanket loan to buy them all. Once a parcel is sold, a portion of the mortgage is released, with the rest of the mortgage remaining intact. Traditional mortgages typically have a "due-on-sale clause", which stipulates that if property secured by the mortgage is sold, the entire outstanding mortgage debt must be paid in full immediately. With a blanket mortgage, a "release clause" allows the sale of portions of the secured property and corresponding partial repayment of the loan. This is done to facilitate purchases and sales of multiple units of property with the convenience of a single mortgage. What is a Bridge loan?A bridge loan (or swing loan) is a type of short-term loan in the financial industry. Bridge loans are typically taken out for a period of 2 weeks to 3 years in order to finance projects. Bridge loans are often used for commercial real estate purchases, to quickly close on a property, retrieve real estate from foreclosure, and to take advantage of a short-term financing opportunity in order to secure long term financing. Speed is a bridge loan's number one asset. A bridge loan is similar to a hard money loan. The primary difference between the two is that a hard money loan can refer to a distressed property or situation. A bridge loan may be simply a similar or higher interest loan that provides interim financing for an individual or business until permanent or the next stage of financing can be issued. For example a land loan for an investor might only cover 50% of the property value. A bridge loan might lend additional funding during the permit phase. The construction loan will be issued usually after the permits are issued and approved. Then the end loan or traditional mortgage will be issued after the certificates of completion are issued by the local building department. Example: If you are trying to convert an apartment
complex into condos and a bank will provide you with a sum of
money only after a five month period, you might take out a bridge
loan to finance your project while you are waiting for the bank.
What is a Buy-down mortgage?A buy-down is a mortgage financing technique where the buyer attempts to obtain a lower interest rate for at least the first few years of the mortgage. The seller of the property usually provides payments to the mortgage lending institution, which, in turn, lowers the buyer's monthly interest rate and therefore monthly payment. This is typically done for a period of about one to five years. In a seller's market the seller might raise the purchase price to compensate for the costs of the buydown but in most markets it would not be to their advantage to use a buydown as an enticement if they are going to offset the benefit by raising the price. In most cases, the buydown does not even involve the seller. It is an arrangement between the lender and the buyer.You may also use the buydown option on a refinance. What is an Equity loan?An equity loan is a mortgage placed on real estate in exchange for cash to the borrower. For example, if a person owns a home worth $100,000, but does not currently have a lien on it, they may take an equity loan up to 90% loan to value (LTV) or $90,000 in cash in exchange for a lien on title placed by the lender of the equity loan. Many lending institutions require the borrower to repay only an interest component of the loan each month (calculated daily, and compounded to the loan once each month). The borrower can apply any surplus funds to the outstanding loan principal at any time, reducing the amount of interest calculated from that day onwards. Some loan products also allow the possibility to redraw cash up to the original LTV, potentially perpetuating the life of the loan beyond the original loan term. The rate of interest applied to equity loans is much lower than that applied to unsecured loans, such as credit card debt. What is Foreign National mortgage?A mortgage to a non resident is called a Foreign National Mortgage loan. A foreign national who is not a resident of the United States will in many cases seek to own real estate. Financing real estate is generally done by US mortgage companies and banks to United States citizens. Lenders also offer loans to non citizens. They may be resident aliens, temporary residents or other classifications of either temporary or permanent status. Down payment requirements are usually higher for foreign national borrowers. The minimum down payment is usually 20% of the total purchase price of the property. This is also referred to as an 80% Loan to Value "LTV" loan. What is a Graduated payment mortgage loan?A graduated payment mortgage loan, often referred to as GPM, is a mortgage with low initial monthly payments which gradually increase over a specified time frame. These plans are mostly geared towards young men and women who cannot afford large payments now, but can realistically expect to do better financially in the future. For instance a medical student who is just about to finish medical school might not have the financial capability to pay for a mortgage loan, but once he graduates, it is more than probable that he will be earning a high income. It is a form of negative amortization loan.
What is a Hard money loan?A hard money loan is a specific type of financing in which a borrower receives funds based on the value of a specific parcel of real estate. Hard money loans are typically issued at much higher interest rates than conventional commercial or residential property loans and are almost never issued by a commercial bank or other deposit institution. Hard money is similar to a bridge loan which usually has similar criteria for lending as well as cost to the borrowers. The primary difference is that a bridge loan often refers to a commercial property or investment property that may be in transition and not yet qualifying for traditional financing. Whereas hard money often refers to not only an asset-based loan with a high interest rate, but can signify a distressed financial situation such as arrears on the existing mortgage or bankruptcy and foreclosure proceedings are occurring. Loan StructureA hard money loan is a species of real estate loan collateralized against the quick-sale value of the property for which the loan is made. Most lenders fund in the first lien position, meaning that in the event of a default, they are the first creditor to receive remuneration. Occasionally, a lender will subordinate to another first lien position loan; this loan is known as a mezzanine loan or second lien. Hard money lenders structure loans based on a percentage of the quick-sale value of the subject property. This is called the loan-to-value or LTV ratio and typically hovers between 60-70% of the market value of the property. For the purpose of determining an LTV, the word "value" is defined as "today's purchase price." This is the amount a lender could reasonably expect to realize from the sale of the property in the event that the loan defaults and the property must be sold in a one- to four-month timeframe. This value differs from a market value appraisal, which assumes an arms-length transaction in which neither buyer nor seller is acting under duress. Below is an example of how a commercial real estate purchase might be structured by a hard money lender:
What are Jumbo Mortgages?In the United States, a jumbo mortgage is a mortgage with a loan amount above the industry-standard definition of conventional conforming loan limits. This standard is set by the two largest secondary market lenders, Fannie Mae and Freddie Mac. Loans above the conforming limits may be offered by seller servicers of these wholesale institutions, as well as Wall Street conduits who provide warehouse financing for mortgage lenders. The loan amounts reflect average loan sizes nationwide. Jumbo mortgages apply when agency (FNMA and FHLMC) limits don't cover the full loan amount. Fannie Mae (FNMA) and Freddie Mac (FHLMC) are large agencies that purchase the bulk of residential mortgages in the U.S. They set a limit on the maximum dollar value of any mortgage they will purchase from an individual lender. As of 2006, the limit is $417,000, or $625,500 in Alaska, Hawaii, Guam, and the U.S. Virgin Islands. Other large investors, such as insurance companies and banks, step in to fill the need, with maximum mortgage amounts going to the $1 million or $2 million range. A loan in excess of $650,000 is referred to as a super jumbo mortgage. The average interest rates on jumbo mortgages are typically greater than is normal for conforming mortgages, and vary depending on property types and mortgage amount. RiskJumbo mortgage loans are a higher risk for lenders. This is because if a jumbo mortgage loan defaults, it is harder to sell a luxury residence quickly for full price. Luxury prices are more vulnerable to market highs and lows. That is one reason lenders prefer to have a higher down payment from jumbo loan seekers. Jumbo home prices can be more subjective and not as easily sold to a mainstream borrower, therefore many lenders may require two appraisals on a jumbo mortgage loan. The interest rate charged on jumbo mortgage loans is generally higher than a loan that is conforming, due to the slightly higher risk to the lender. It can vary but is generally 0.25% to 0.5% higher. Loan optionsJumbo mortgage loan options are similar to traditional loan programs. They simply require a slightly higher down payment, usually of an additional 5% for similar program types. No-money-down programs are generally not available, but instead require a minimum of 5% down payment for a jumbo mortgage. Because the loans are large, jumbo lenders frequently offer variable loan programs to the jumbo client. The risk of an interest rate increase can result in a large dollar amount increase. Generally, adjustable rate mortgages are popular due to the low payment. It can be more expensive to refinance a jumbo loan due to the closing costs. Some lenders will offer the service of an extension and consolidation agreement, so that a jumbo refinancer will not have to pay for mortgage tax again on the same principal balance. In other cases, title insurance companies will offer up to a 50% discount, often required by law for those refinancing within 1 year to 10 years. The largest discount is for refinancing within one year. Some consumers seeking a jumbo mortgage choose to seek advice from a competent professional familiar with jumbo mortgage loans. Recent trendsDue to increased housing prices, there is a large increase in the number of jumbo loan applicants. Many consumers are becoming jumbo borrowers when buying a modest ranch or Cape Cod house; this option is no longer limited to high-end luxury residences. New loan programs are now offered to address the large increase in jumbo loan applications. Because of the steep price increases during the recent years (2000-2006), mortgage loans are required in excess of the conforming limits in most big-city areas or their surrounding suburbs. The new loans are either a 40- or even 50-year amortization, or an interest-only option. They allow the jumbo loan borrower to pay the loan back over a longer period of time, or to defer any repayment of principal for a few years-thus saving them on their monthly payment. In some cases, the banker makes a larger profit if the loan takes more than 30 years to repay. Popular Programs Avoid Costly Private Mortgage Insurance ("PMI") 80/20 & 80/15 jumbo loan programs are very popular with new home purchasers. Because any borrower with less than a twenty percent down payment was previously subject to purchasing private mortgage insurance (PMI) to insure the lender for the higher risk, jumbo borrowers were previously paying a very large PMI fee on a loan with an LTV (loan-to-value ratio) higher than 80%. Now, the jumbo borrower can borrow the 80% without PMI, and take a second mortgage at a slightly higher intererst rate, which does not require PMI, and hedges the risk of the first position lender at the lower interest rate. What is Package loan/Mortgage?A package loan is a real estate loan used to finance the purchase of both real property and personal property, such as in the purchase of a new home that includes carpeting, window coverings and major appliances. What is a Participation Mortgage?A participation mortgage is a mortgage wherein the lender, or mortgagee, is entitled to share in the rental or resale proceeds from a property owned by the borrower, or mortgagor. A participation mortgage may or may not require principal and interest payments, and may or may not contain a balloon payment. For instance, Michael has a loan for a shopping center including 12 separate units. All are rented / leased and in addition to the principal and interest he pays to the lender, he is required to pay a certain percentage of the incoming funds. The lender is then participating in the income stream provided by the particular property. What is a Reverse mortgage?A reverse mortgage (known as lifetime mortgage in the United Kingdom) is a loan available to seniors (62 and over in the United States), and is used to release the home equity in the property as one lump sum or multiple payments.
If a property has increased in value after a reverse mortgage is taken out, it is possible to acquire a second (or third) reverse mortgage over the increased equity in the home. But in certain countries (including the United States), a reverse mortgage must be the first and only mortgage on the property. Requirements of the Reverse Mortgages
The counseling is a safeguard for the borrower and his/her family, to make sure the borrower completely understands what a reverse mortgage is and how one is obtained. The American Association of Retired Persons (AARP) has proposed a plan for keeping closing costs low for seniors who qualify for reverse mortgages. The plan must be approved by the federal government and is controversial for a number or reasons. One possible disadvantage is that homeowners will be limited to Bank of America, Countrywide, or Wells Fargo. Payment(s) (loan advances)The amount of money that an individual homeowner can receive from a reverse mortgage depends on his or her age, the Federal Housing Administration (FHA) or Fannie Mae (FNMA) appraised value of the home, and the starting interest rate (effective upon closing/finalization of the loan). The location of the home may also have an impact. There is also a type of reverse mortgage for homes valued over the maximum Fannie Mae limit. These are called "cash" accounts, and are proprietary loan products. In a reverse mortgage in the U.S., a borrower can be paid in a lump sum, monthly (payment of advances), through an increasing line of credit, or a combination of all three. The money received (loan advances) are not taxable and do not directly affect Social Security or Medicare benefits. However, an American Bar Association guide to reverse mortgages explains that if you receive Medicaid, SSI, or other public benefits, loan advances will be counted as "liquid assets" if the money is kept in an account (savings, checking, etc.) past the end of the calendar month in which it is received. The borrower could then lose eligibility for such public programs if his or her total liquid assets (cash, generally) is then greater than those programs allow. A borrower can elect to move available funds into a "set-aside" account, similar to a typical escrow account, to pay for his or her future property taxes and/or homeowners insurance. Currently, most reverse mortgage borrowers do not exercise this option and instead elect to be responsible for the payment of taxes and/or insurance on their own. It is important to note that the homeowner must ensure that taxes and insurance are kept current at all times. If either taxes or insurance lapse, it could result in a default on the reverse mortgage. Costs and interest ratesThe cost of getting a reverse mortgage from a private sector lender may exceed the costs of other types of mortgage or equity conversion loans. Exact costs depend on the particular reverse mortgage program that the borrower acquires. For the most popular type of reverse mortgage in the U.S., the FHA-insured Home Equity Conversion Mortgage (HECM), there is an insurance premium of 2% of the loan and a 2% origination fee in addition to normal closing costs, which are typically several thousand dollars, but vary depending on the third-party costs (appraisal fees, title searches, etc.) that must be undertaken. Thus a $250,000 loan would have $9,000 in costs beyond the normal closing costs added onto the loan at the outset. Other programs skip the insurance premium but still require the origination fees and closing costs, and some programs waive the initial costs if the borrower borrows all or most of the maximum amount that he or she is eligible to receive. In addition, a monthly service charge (between $25 and $35) is usually added to the total amount of the loan. In all of these cases, the costs of a reverse mortgage can typically be financed with the proceeds of the loan itself, with the costs and fees being rolled directly into the principal balance of the loan, rather than paid by the borrower in cash. While this does permit borrowers with little or no available cash to get a reverse mortgage, it means that the initial loan principal will be increased, and consequently, that the fees will begin accruing interest. Interest rates on reverse mortgages are determined on a program-by-program basis, but are typically similar to interest rates offered by Adjustable Rate Mortgages (ARMs). All major reverse mortgage programs have adjustable interest rates that are adjusted on an annual, semi-annual, or monthly basis. ecause reverse mortgages have no fixed duration, typically there are no reverse mortgages with fixed interest rates. There are now some new reverse mortgage programs that have fixed interest rates. Some state and local governments offer low-cost reverse mortgages to seniors. These "public sector" loans generally must be used for specific purposes, such as paying for home repairs or property taxes, but most of them are insured by the Federal Housing Administration (FHA) and often have more favorable interest rates and fewer or no fees associated with them. These programs are typically very restrictive in terms of qualification and location, and many regions, states, and areas do not have such programs at all. What is a Repayment Mortgage?A repayment mortgage is a term generally used to describe a mortgage in which the monthly repayments consist of repaying the capital amount borrowed as well as the accrued interest. The mortgage statement, usually received annually, shows the amount borrowed decreases throughout the term. The big advantage of a repayment mortgage is that at the end of the mortgage term, the full amount of the debt has been repaid. It also removes the risk of having an investment, the performance of which is dependent on the stock market. The borrower is less likely to suffer from negative equity because the mortgage balance will be reducing month on month. As time moves on, the equity percentage in the property increases. However, in the early years the bulk of the mortgage repayments consist of the interest component, so not much of the capital is actually paid off for some time. What is a Seasoned mortgage?Mortgage which has been paid in a timely manner by Mortgagor, typically for no less than six months, often for more than one year. A term associated with the secondary market where lots of mortgages with similar characteristics are bought and sold in bulk. What is a Term loan or Interest-only loan?An interest-only loan is a loan in which for a set term the borrower pays only the interest on the principal balance, with the principal balance unchanged. At the end of the interest-only term the borrower may enter an interest-only mortgage, pay the principal, or (with some lenders) convert the loan to a principal and interest payment (or amortized) loan at his/her option. The main alternative to capital and interest mortgage is an interest only mortgage, where the capital is not repaid throughout the term. This type of mortgage is common in the UK, especially when associated with a regular investment plan. With this arrangement regular contributions are made to a separate investment plan designed to build up a lump sum to repay the mortgage at maturity. This type of arrangement is called an investment-backed mortgage or is often related to the type of plan used: endowment mortgage if an endowment policy is used, similarly a Personal Equity Plan (PEP) mortgage, Individual Savings Account (ISA) mortgage or pension mortgage. Historically, investment-backed mortgages offered various tax advantages over repayment mortgages, although this is no longer the case in the UK. Investment-backed mortgages are seen as higher risk as they are dependent on the investment making sufficient return to clear the debt. It is not uncommon for interest only mortgages to be arranged without a repayment vehicle, with the borrower gambling that the property market will rise sufficiently for the loan to be repaid by trading down at retirement (or when rent on the property and inflation combine to surpass the interest rate). What are Interest-Only Mortgages?In the United States, a five or ten year interest-only period is typical. After this time, the principal balance is amortized for the remaining term. In other words, if a borrower had a thirty-year mortgage loan and the first ten years were interest only, at the end of the first ten years, the principal balance would be amortized for the remaining period of twenty years. The practical result is that the early payments (in the interest-only period) are substantially lower than the later payments. This gives the borrower more flexibility because they are not forced to make payments towards principal. Indeed, it also enables a borrower who expects to increase their salary substantially over the course of the loan to borrow more than they would have otherwise been able to afford, or investors to generate cash flow when they might not otherwise be able to. During the interest only years of the mortgage, the loan balance will not decrease unless the borrower makes additional payments towards principal. Under a conventional amortizing mortgage, the portion of a payment that represents principal is very small in the early years (the same period of time that would be interest only). Interest only loans represent a somewhat higher risk for lenders, and therefore are subject to a slightly higher interest rate. Combined with little or no down payment, the adjustable rate (ARM) variety of interest only mortgages are sometimes indicative of a buyer taking on too much risk- especially when that buyer is unlikely to qualify under more conservative loan structures. Because a homeowner does not build any equity in an interest-only loan they may be adversely affected by prevailing market conditions at the time they are either ready to sell the house or refinance. They may find themselves unable to afford the higher regularly amortized payments at the end of the interest only period, unable to refinance due to lack of equity and unable to sell if demand for housing has weakened. Due to the speculative aspects of relying on home appreciation which may or may not happen, many financial experts advise against interest only loans for which a borrower would not otherwise qualify for. What is a Wraparound mortgage?A wraparound is a way of lowering the barriers of entry to a junior lien or subordinate mortgage; it also expedites process of purchasing a home. A junior lien or subordinate mortgage is a second mortgage that generally sits behind larger first mortgage. Here is an example of wraparound: The seller, who has the original mortgage, sells his home with the existing first mortgage in place and a second mortgage which he "carries back" from the buyer. The mortgage he takes from the buyer is for the amount of the first mortgage, plus a negotiated amount less than or up to the sales price minus the down payment and closing costs. The seller then continues to pay the first mortgage with the proceeds of the second. Once the second mortgage is satisfied, the seller is out, but this is rarely the case. Typically, the seller also charges a "middle" on the first mortgage. For example, one has a first mortgage at 6% and sells the whole property with a rate of 8% on a wraparound mortgage. He/she make a 2% middle on the first mortgage amount, using other people's money to make money. So, it is in the best interests of a seller to keep the wrap, rather than allow the buyer to assume the first mortgage. There are relatively few wraparounds today because the first mortgage must be assumable, or the mortgagee must permit this type of assumption to occur on the loan. Today, only the FHA writes assumable loans, as most mortgage bankers have found that the main expenses (and profits) of a transaction occur at origination. Most mortgages have a due on sale clause to prevent the use of wraparounds. What is an Option ARM?An option ARM provides the option to pay as little as the equivalent of an amortized payment based on a 1% interest rate,(please note this is not the actual interest rate). As a result, the difference between the monthly payment and the interest on the loan is added to the loan principal; the loan at this point has negative amortization. In this respect, an option ARM provides a form of equity withdrawal (as in a cash-out refinancing) but over a period of time. The option ARM gives a number of payment choices each month (for example, the equivalent of an amortized payment were the interest rate 1%, interest only based on actual interest rate, actual 30 year amortized payment, actual 15 year amortized payment). The interest rate may adjust every month in accordance with the index to which the loan is tied and the terms of the specific loan. These loans may be useful for people who have a lot of equity in their home and want to lower monthly costs; for investors, allowing them the flexibility to choose which payment to make every month; or for those with irregular incomes (such as those working on commission or for whom bonuses comprise a large portion of income). One of the important features of this type of loan is that the minimum payments are often fixed for each year for an initial term of up to 5 years. The minimum payment may rise each year a little (payment size increases of 7.5% are common) but remain the same for another year. For example, a minimum payment for year 1 may be $1,000 per month each month all year long. In year 2 the minimum payment for each month is $1,075 each month. This is a gradual increase in the minimum payment. The interest rate may fluctuate each month, which means that the extent of any negative amortization cannot be predicted beyond worst-case scenario as dictated by the terms of the loan. Option ARM mortgages have been criticized on the basis that some borrowers are not aware of the implications of negative amortization; that eventually option ARMs reset to higher payment levels (an event called "recast" to amortize the loan), and borrowers may not be capable of making the higher monthly payments; and that option ARMs have been used to qualify mortgages for individuals whose incomes cannot support payments higher than the minimum level. Negative amortization loanIn finance, negative amortization, also known as NegAm, is an amortization method in which the borrower pays back less than the full amount of interest owed to the lender each month. The shorted amount is then added to the total amount owed to the lender. Such a practice would have to be agreed upon before shorting the payment so as to avoid default on payment. Also known as deferred interest or Graduated Payment Mortgage (GPM). Defining characteristics of Neg AmNegative amortization only occurs in loans in which the periodic payment does not cover the amount of interest due for that loan period. The result of this is that the loan balance (or principal) increases by the amount of the unpaid interest. The purpose of such a feature is to increase affordability, or add payment savings and payment flexibility to a loan. Neg-Ams also have what is called a recast period and recast principal balance cap based on Federal and State legislation. The recast period is usually 60 months (5 years). The recast principal balance cap is usually up to a 125% increase of the amortized loan balance over the original loan amount. States and lenders can offer products with lesser recast periods and principal balance caps; but cannot issue loans that exceed their state and federal legislated requirements under penalty of law. A newer loan option has been introduced which allows for a 40 year loan term. This makes the minimum payment even lower than a comparable 30 year term. In economics, it is between a zero coupon and a straight coupon bond. Typical Circumstances of Option ArmAll NegAM home loans eventually require full repayment of principal and interest according to the original term of the mortgage and note signed by the borrower. Most loans only allow NegAM to happen for no more than 5 years, and have terms to "Recast" (see below) the payment to a fully amortizing schedule if the borrower allows the principal balance to rise to a pre-specified amount. This loan is written often in high cost areas, because the monthly mortgage payments will be lower than any other type of financing instrument. Negative amortization loans can be high risk loans for inexperienced investors. These loans tend to be safer in a falling rate market and riskier in a rising rate market. Start rates on negative amortization or minimum payment option loans can be as low as 1%. This is the payment rate, not the actual interest rate. The payment rate is used to calculate the minimum payment. Other minimum payment options include 1.95% or more. Adjustable Rate FeatureNegAM loans today are mostly straight Adjustable Rate Mortgages (ARMs), meaning that they are fixed for a certain period and adjust every time that period has elapsed; e.g., one month fixed, adjusting every month. The NegAm loan, like all Adjustable Rate Mortgages, is tied to a specific financial index which is used to determine the interest rate based on the current index and the margin (the markup the lender charges). Most NegAm loans today are tied to the Monthly Treasury Average,
in keeping with the monthly adjustments of this loan. There are
also Hybrid ARM loans in which there is a period of fixed payments
for months or years, followed by an increased change cycle, such
as six months fixed, then monthly adjustable. The most notable differences between the Traditional Payment
Option Arm and the Hybrid Payment Option Arm are in the start
rate also known as the "minimum payment" rate. On a
Traditional Payment Option Arm, the minimum payment is based on
a principal and interest calculation of 1% - 2.5% on average. On a Hybrid Payment Option Arm, the minimum payment is derived using the "interest only" calculation of the start rate. The start rate on the Hybrid Payment Option arm typically is calculated by taking the Fully Indexed Rate (Actual Note Rate), then subtracting 3%, which will give you the start rate. Example:
This guideline can vary among lenders. Aliases the Payment Option Arm loans are known by:
Criticisms of Negative Amortization loansNegative Amortization loans, being relatively popular only in the last decade, have attracted a variety of criticisms:
NegAm - Mortgage Terminology
What are Non-Conforming MortgageA non-conforming mortgage is a term in the United States for a residential mortgage that does not conform to the loan purchasing guidelines set by the Federal National Mortgage Association /Federal Home Loan Mortgage Corporation (Fannie Mae and Freddie Mac). Specifically, it has a dollar amount over the purchasing limit set by FNMA/FHLMC. These loans must remain in a lender's portfolio, or be sold to other companies who purchase larger loan amounts. Consequently, a premium is paid by those obtaining non-conforming mortgages, generally .25% or .5 points more than the same loan would cost if it were conforming. The loan amount is adjusted every few years depending upon the average sales price of homes in the U.S. History of conforming loan limits
Standard or conforming mortgagesMany countries have a notion of standard or conforming mortgages that define a perceived acceptable level of risk, which may be formal or informal, and may be reinforced by laws, government intervention, or market practice. For example, a standard mortgage may be considered to be one with no more than 70-80% LTV and no more than one-third of gross income going to mortgage debt. A standard or conforming mortgage is a key concept as it often defines whether or not the mortgage can be easily sold or securitized, or, if non-standard, may affect the price at which it may be sold. In the United States, a conforming mortgage is one which meets the established rules and procedures of the two major government-sponsored entities in the housing finance market (including some legal requirements). In contrast, lenders who decide to make nonconforming loans are exercising a higher risk tolerance and do so knowing that they face more challenge in reselling the loan. Many countries have similar concepts or agencies that define what are "standard" mortgages. Regulated lenders (such as banks) may be subject to limits or higher risk weightings for non-standard mortgages. For example, banks in Canada face restrictions on lending more than 75% of the property value; beyond this level, mortgage insurance is generally required (as of April 2007, there is a proposal to raise this limit to 80%). |
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